Appraisal – An Investors Best Friend or Enemy
Real estate appraisal, land valuations, or property valuations are different ways of valuing real properties. Generally, the value sought is the market value of the property. Assessments performed by real estate appraisers are a necessary aspect of these transactions because these deals occur infrequently compared to investments like corporate stock transactions. Aside from that, every property is unique, which is also different from corporate stock and similar assets.
Why is a Professional Real Estate Appraisal Needed For Real Estate Valuation?
Every property is different in terms of its location, which is a crucial aspect regarding their value. A centralized Walrasian auction setting works perfectly well for stock markets and exchanges like trading corporate stock. However, it just won’t work in property asset trading. The lack of regular trading, unlike stocks, and the product differentiation aspect, are factors that make it necessary to have qualified, professional appraisers for sound advice on the property’s value.
The real estate appraiser will provide a written report that mentions the value to their client. These reports are crucial in real estate transactions. They become the basis for tax matters, settling divorces, estates as well as for mortgage loans. At times, both parties involved use this appraisers report while setting the appraised property’s value.
In some regions, appraisers don’t need certification or licensing to value properties. However, most areas require appraisers to be certified or licensed. Sometimes, the Appraiser may also be called a Land Valuer or Property Valuer.
If the Appraiser is basing their opinion on Market Value, they also need to base it on the Best and Highest use of the real property. In the United States, when Appraisers perform mortgage valuations on improved residential property, a Uniform Residential Appraisal Report form will be used. This form has a standardized format. However, when more complex properties (example- raw land or income-producing) are valued, the appraiser reports are in a narrative form.
Different Types of Value
Real estate appraisers provide reports based on various value definitions and types; some of the commonest ones are:
- Market Value – It is the price at which assets would trade in any competitive Walrasian auction setting. It is also referred to as a fair value or market value.
- Market Value IVS (International Valuation Standards) Definition- The estimated amount at which a liability/asset should exchange on a particular valuation date between willing buyers and sellers in a transaction that takes place at arm’s length. The other condition is that both the parties should have acted without any compulsion, prudently, and knowledgeably.
- Use Value? Value-In-Use – The NPV (net present value) of a cash flow which an asset generates for a specific owner under a particular use. Value-in-use refers to the property value as to an individual user. It can be either below or above the property’s market value.
- Investment Value- This is the value to one specific investor. It may or may not be above the property’s market value. Buyers or sellers are generally motivated to enter the marketplace by the difference between an asset’s market value and its investment value.
- Investment value IVS (International Valuation Standards) Definition – The asset’s value to the owner or prospective owner for operational objectives or individual investment.
- Insurable Value– Is the real property’s value that an insurance policy covers. This figure typically doesn’t include the site value.
- Liquidation Value – This can be analyzed either as an orderly liquidation or forced liquidation and is an accepted standard of value sought in bankruptcy proceedings. This form of value assumes a seller left with no option but to sell, post an exposure timeframe that is less than the standard or market-normal deadline.
Price versus Value
In any transaction, there can be a difference between the market value (actual worth of the property) and its price (its purchase price). The amount paid may be entirely different from the market value of that property. In some cases, there could be special considerations like:
- One of the parties has significant influence or control over the other.
- The buyer and seller share a special relationship.
- That particular property may be only one of several different or related properties that have been traded or exchanged hands between two parties.
In all these situations, the price paid for a specific property cannot be considered to be its market value, but its market price (the premise typically is that in total, the prices for all the pieces will ultimately add up to the overall market value)
In other cases, the buyer is more than willing to fork out a premium price that is far above the market value. They do this if the investment value for them (subjective valuation of that property) is above the market value. For example, an owner combines their adjacent property with the subject property to gain from the economies-of-scale.
Sometimes, similar situations occur in corporate finance like they do in acquisitions or mergers. These can take place at prices that are far higher than the value that the underlying stock represents.
In these types of acquisitions and mergers, the usual explanation is- “the sum is much greater than its parts.” It’s because 100% ownership of a company also means the buyer gets full control of it. In some situations, purchasers may be willing to loosen their purse strings and pay a higher price. A similar situation can take place in real estate transactions, as well.
However, the most common reason that value differs from price is when either the seller or buyer is uninformed about the market value of the property. In spite of this, they sign a contract at a price that lies in the median range. This type of deal can be less profitable for one of the parties involved. The real property appraiser is obligated to estimate what the property’s actual market value is, and not the market price.
Market Value Definitions in the United States
The United States requires licensed real estate appraisers to perform formal valuations for specific types of value, such as investment value, distressed sale value, fair market value, foreclosure value, and others. However, Market Value is the most commonly used definition of value.
The USPAP (Uniform Standards of Professional Appraisal Practice) doesn’t have a specific definition for Market Value. But there is generic guidance on it:
Market Value- “A type of value, stated as an opinion that presumes the transfer or sale of a property as of a certain date, under specific conditions outlined in the definition of the term identified by the appraiser as applicable.”
Therefore, the definition of value when used in a Current Market Analysis (CMA) and report is a broader set of market assumptions. In these assumptions, there may be a transaction related to the subject property. It has an impact on the comparable data used in the analysis, and it can have a bearing on the property valuation method used as well. For instance, tree value may account for up to 25% of the overall property value.
Three Distinct Ways to Approach Value
A real estate appraiser can determine value via three conventional methodology groups. Usually, these “three approaches to value” are independent of each other:
- The cost approach is when the buyer doesn’t pay a higher amount for a property than what it would cost to buy an equivalent one.
- The sales comparison approach is when a real estate appraiser values a property’s characteristics compared with other property sales with similar features and transactions.
- The income capitalization approach is akin to the methods used for bond pricing, security analysis, or financial valuation.
Which Is the Right Approach to Valuation?
The modern business trend leans towards the utilization of a scientific methodology in which the valuation is done based on geographical, risk, and quantitative data approaches. Here we look at the comparison between traditional and modern approaches to understand the methods the industry uses.
As mentioned earlier, an appraiser has the option to choose between any one of the three approaches while determining value. In most instances, one or two of these mentioned approaches will be most suitable, while the other one, not so much. Appraisers will take certain things into account such as the “scope of the work,” the property itself, the type of value as well as the quantity and quality of data available for each of these approaches.
It would be inaccurate to state that any specific approach is better than the others. It’s the Appraiser’s job to determine how most users typically buy a particular type of property. The Appraiser would use this as a guiding point when deciding which valuation method would be the best in that situation. They would determine this while keeping the available data in view at all times. Here are some examples:
- If the valuation is for a property that an investor is purchasing (e.g., an office building or a skyscraper), the Appraiser may use the Income Approach more than the others.
- A buyer who has shown interest in buying a residential property like a single-family home, a market analysis approach, or the Sales Comparison Approach would be better suited.
- If the valuation is for the construction of a new building or structure, the Cost Approach would be most useful as it would help to determine insurable value.
- A single apartment building of a given quality will generally sell at a specific price per apartment. In most of these cases, the appraisers would use a Sales Comparison approach.
- If an apartment complex with multiple buildings has to be valued, the real estate appraiser will use the Income Approach because that’s the method that most prospective buyers would use while valuing the property.
- When single-family homes are valued, most valuation weight is to the Sales Comparison method of valuation.
- But if the said single-family home is in a neighborhood where a large percentage or all of the properties are rental dwellings, it can be more useful to include a specific aspect of the Income Approach.
From these examples, it will become more evident that the valuation method chosen can vary depending on the circumstances, even when there isn’t much of a change in the property in question.
A Detailed Look at Valuation Approaches
1. Cost Approach
This method used to be called the summation approach. Theory say it is possible to estimate the property through the sum of the land value of the property and the depreciated value of improvements if any exist. Reproduction cost new less depreciation or replacement cost minus depreciation (RCNLD) is the term used to describe the value of the included improvements.
Here, the word “reproductions” refers to the reproduction of a replica. The replacement cost is the cost of constructing a house or making other improvements that have the same utility. However, in these works, modern design, materials, and quality are used. Most appraisers, in practice, tend to use Replacement Cost. From this, they deduct one factor for functional dis-utilities associated with the subject property’s age.
However, in some Insurance Valuations, there may be an exception made to the standard rule where the Appraiser will use the Replacement Cost method. The goal is to reproduce an exact asset after a destructive event like a flood or fire.
In most cases, when using the Cost Approach, the methodology also has a Sales Comparison component. This hybrid helps to represent the price the customer is seeking as well as the supplier’s cost. For example, if the Appraiser uses the replacement cost for constructing a building, expenses such as material and labor would be taken into account. However, the Comparable Sales Data approach would have to be used in the analysis to derive land values as well as depreciation.
The Cost Approach proves extremely reliable when newer structures are being valued. But it isn’t so, in the case of older properties. When assessing a special-use property like a marina or public assembly space, they are valued via the Cost Approach as it is the most reliable.
2. Sales Comparison Approach
This approach is based mainly on the concept of substitution. The Sales Comparison approach assumes that a rational or prudent buyer would not pay more for a property that what it would cost them to buy a comparable property with similar characteristics. In this case, the assumption is that typical buyers do research and compare asking prices. They always look to buy a property at the lowest cost, but one that meets their needs perfectly.
While using the Sales Comparison Approach, the Appraiser tries to measure and accurately interpret the actions of all the parties involved, including sellers, buyers, and investors. They collect Valuation Process data on properties that have been recently sold and were comparable to the property that is in valuation.
Only properties that have sold will be used to determine the property’s value. The reason is they are a representation of the amounts that were agreed upon or paid for the properties. There are different sources of comparable data, such as:
- Public records
- Real estate publications
- Real estate brokers
- Real estate agents
All the appraiser details all vital information related to every comparable sale described in the appraisers report. Since similar, comparable sales will have some differentiating factors from the subject property, the Appraiser might make adjustments for the location, date of purchase, amenities, site size, amenities style, and more.
If the similar property’s aspects or features are superior to the subject, then the Appraiser would make a downward adjustment for that specific factor. On the other hand, if the comparable property’s aspects or features are inferior to the subject, the Appraiser would make an upward adjustment for that particular factor.
It’s essential to note that the adjustment is mostly subjective as the Appraiser’s experience and training come into the picture. The professional will analyze all the adjusted sales prices of comparable property sales. Based on their assessment, the Appraiser will then select a value indicator that represents the subject property closely. Different appraisers may choose various value indicators, which also means they may ultimately provide different property values.
Sales Comparison Approach- The Steps
- Conduct thorough market research and gather information related to sales and of pending sales, similar to the property to be valued.
- Carry out a detailed investigation of market data to determine its accuracy and factual correctness.
- Determine what the units of comparison are and develop a comparative analysis of all the relevant aspects such as sales price per square foot.
- Carefully compare the subject with comparable sales based on the comparison elements and make the necessary adjustments.
- Reconcile all the multiple value indications which emerge from either the upward or downward adjustment of the comparable sales and turn them into just a single value indication.
The Income Capitalization Approach
Real estate professionals will often refer to this form of valuation as the “income approach.” Appraisers will use this valuation form for investment and commercial properties. It is intended to model or directly reflect the overall behaviors and expectations of typical participants in the market. It’s also why appraisers commonly use the Income Approach in the valuation of income-producing properties, where plenty of market data is easily accessible.
In commercial income-producing properties, this particular approach creates a value indication by capitalizing on an income stream. Capitalization rates or revenue multipliers are applied to an NOI (Net Operating Income.) In most cases, the NOI has already stabilized, so it doesn’t place excessive weight on very recent events. A simple example would be an unleased building. Technically, this property would not have any Net Operating Income.
A stabilized Net Operating Income would assume that the said building leased to normal occupancy levels at an average rate. The NOI is the GPI (Gross Potential Income), with the vacancy and collection loss deducted from it (= Effective Gross Income), less the operating expenses (excluding income taxes, debt service, and any depreciation charges that the accountants have applied).
If multiple years of net operating income has to be valued, the Appraiser can use the DCF analysis (discounted cash flow), model. This model is generally used to assess income-producing, expensive, more significant properties such as shopping malls and large office buildings. In this technique, the appraisal will apply discounted rates or market-supported yields to the projected future cash flows (like annual income figures which are generally are a lump reversion from the final sale of the property). It helps the Appraiser determine the building’s present value.
Methods of Valuation
Conventionally valuation methodology has five distinct classifications:
- Comparative Method– This method works well for valuing most property types that have strong evidence of prior sales. To a certain extent, it is similar to the Sales Comparison approach mentioned above.
- Investment Method– The method is ideal for most residential and commercial properties that are being let out and producing some future cash flows. If the current ERV (Estimated Rental Value), market-determined equivalent yield, and the passing income are known, a simple model can be used to determine the property value. Note that this is a Comparison Method because of all the defined critical variables in the existing market. However, in standard practices in the United States, capitalizing of NOI is used in conjunction with the DCF method under the income capitalization approach’s general classification.
- Residual Method- This method is used for bare land or properties that are ready either for redevelopment or new development.
- Profit Method– It is commonly used for trading properties such as retirement or assisted living homes, restaurants, and hotels, where there is slight evidence of rates. An appropriate yield is used to capitalize on a 3-year average of the operating income, which is derived either from the income or profit & loss statement. Note- As the variables are considered to be inherent to the property, they aren’t market-derived. So, unless the Appraiser makes the appropriate adjustments, the resulting value will be the Investment Value or Value-in-Use rather than the Market Value.
- Cost Method- This Appraiser uses this method for buildings or land of specific character for which it isn’t possible to obtain profit figures. The Appraiser will also use it for buildings or land that don’t have a market because of their heritage or public service features. Under the Cost Approach, the Appraiser will use the residual method and the Cost Method in tandem.
Other Considerations in the Appraiser Process
The USPAP has always needed that appraisers identify the scope of work required to produce accurate and credible results. But in recent years, it became evident that most appraisers did not fully understand which process they need to follow to develop this adequately. Appraisers, reviewers as well as clients used to become confused with the use of the Departure Rule and the concept of Complete vs. Limited Appraisal, along with the formulated scope of work for a credible valuation.
The Scope of Work Project update was included in the USPAP in 2006, to deal with this issue. With this inclusion, USPAP eliminated both the limited appraisal concept and the Departure. They created a new “Scope of Work” rule, in which appraisers had to identify six main components at the start of each assignment, related to the problem:
- The client and any other intended users
- The definition of value (e.g., foreclosure, investment, market)
- Intended use of the valuation as well as the appraisers report
- The effective date of an analysis
- Any extraordinary assumptions or hypothetical conditions
- All salient features or characteristics of the subject property
Based on all of these aspects, the Appraiser will identify the scope of work required. It will include the extent of the investigation, including the methodologies in regard to appropriate approaches to value. There are specific minimum standards are followed for the scope of work, which are:
- Client as well as other users’ expectations
- The actions of other appraisers that conduct similar assignments
- The Scope of Work becomes the first step of an appraiser process. The Appraiser needs a precise Scope of Work to draw viable conclusions.
When the Scope of Work is defined correctly, the Appraiser can develop the proper value for the subject property. It comes in use for the intended use of that valuation as well as for the intended user. The “Scope of Work” helps to ensure that all the parties involved have clear guidelines and expectations regarding the role of the appraisers report. Appraisers are aided by understanding what is versus what isn’t covered, along with the amount of work that has gone into it.
Ownership Interest- The Different Types
The appraisal report needs to mention the real estate “interest” type assessed. Generally, for most mortgage financings or sales, it’s the fee simple interest that is valued. It is the complete compilation of rights available.
While there are several possible real estate interests, the three common ones are:
- Fee Simple Value – It is the complete ownership in any real estate. In common law countries, it is subject to state-reserved powers (police power, eminent domain, escheat, taxation.)
- Leased Fee Value – It’s the fee simple interest restricted by a lease. In case the contract is at the market rent, then the fee simple value and the leased fee value are equal. Sometimes, the tenant pays less or more than the market. In this case, the residual the leased fee holder owns and the tenancy’s market value could be less or more than the existing fee simple value.
- Leasehold value – This is the interest the tenant holds. If the tenant is paying market rent, the leasehold doesn’t have any market value. But if the tenant is paying less than the market rate, the positive leasehold value would come from the difference between the current value of what the tenant is paying and the present value of market rents.
- An example would be a significant chain retailer who might be successful in negotiating a below-market lease; this could become the anchor tenant for their shopping center. The leasehold value could be transferable to some other anchor tenant. In this case, the retail tenant would have a definite interest in that real estate.
If an inspector conducts a home inspection first and they send the report to the Appraiser, it can help them draw a more useful valuation. Appraisers are not professional home inspectors. But when they have the inspection report, they have all of the details concerning required repairs or construction defects. The report can help them arrive at a different opinion of value (which could be lower than what they would have drawn out otherwise).
This information can prove to be helpful if either or both the parties that are requesting the appraisal buy the property ultimately. This type of situation occurs in legal judgments or divorce settlement properties.
Automated Valuation Models and Mass Appraisals
AVMs (Automated valuation models) are now increasingly accepted. They base them on GIS (geographic information systems) or multiple regression analysis, both of which are statistical models. Automated valuation models can provide accurate results, mainly when used in more homogenous areas. However, there is some evidence which indicates that they aren’t as precise if the appraised property doesn’t fit in well with a particular neighborhood. They do not work well when used in rural areas either.
Attorneys have used automated valuation models in class action litigations, and they have substantiation in State as well as Federal Courts. They are proving to be an excellent method to deal with real estate litigation issues with a broader scope, such as contamination in entire neighborhoods.
Since there are so many different valuation models, you need the services of a certified and experienced appraiser when you are either buying or selling a property. A professional with in-depth knowledge of the different methods would be able to provide a more accurate appraisers report, which will help in the real estate transaction.