Fundamental concepts of Real Estate Appraisal

Presented By: Hari Shanker Manoj Kumar

Naveen Kumar

Recovery in the real estate market normally precedes a recovery in the national economy

• As home construction picks up, employment, and spending increase. This in turn generates even more activity, and the general business cycle heads for recovery

• However, if spending and demand rise beyond the equilibrium point, inflation will recur. If this happens, the RBI my tighten up the money supply, and the mortgage market will start to loose funds, causing real estate industry to decline

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• The real estate market (Cycle) in the short run tends to travel somewhat opposite to the general business cycle.

• When the general economy is at the top of a boom, real estate activity is usually already declining because of a lack of credit. When the general economy slows down, real estate activity may increase as funds flow back into the mortgage market

Important economic features of Real Estate:

• Few participants

• Buyers and sellers are not knowledgeable; the exchange is legalistic, complex, and expensive

• Each parcel of real estate is unique and separate from all others; no two parcels are exactly alike

• The location is fixed; a real estate market is local, not regional or national

• Real estate is purchased infrequently; a home represents the single investment made by the average family

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• Govt. plays a dominant role in encouraging or discouraging real estate development through the use of fiscal and monetary tools.

• Prices are influenced by the interaction of supply and demand, but this interaction is not smooth; the lack of knowledge by either the buyer or seller can distort the prices paid

• Supply of land is fixed

• In short run, land use is also fixed

• A fixed supply means that real estate prices fluctuate with demand

Real Estate Investment Principles

Five major economic characteristics:• Return: recovery of benefits• Management: the supervision needed to

oversee the investment• Taxability• Liquidity: the ease and speed of converting

the investment into cash• Risk: the danger of loss of the investment

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The categories of Risk are:

• Financial risk

• Interest rate risk

• Purchasing power risk

• Social change risk

• Legal change risk

Real estate appraisal • Real estate appraisal, property valuation or land valuation is

the practice of developing an opinion of the value of real property, usually its Market Value.

• The need for appraisals arises from the heterogeneous nature of property as an investment class: no two properties are identical, and all properties differ from each other in their location - which is one of the most important determinants of their value.

• So there cannot exist a centralised Walrasian auction setting for the trading of property assets, as there exists for trade in corporate stock.

• The absence of a market-based pricing mechanism determines the need for an expert appraisal/valuation of real estate/property

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• A real estate appraisal is generally performed by a licensed or certified appraiser (in many countries known as a Property Valuer or Land Valuer and in British English as a "valuation surveyor").

• If the appraiser's opinion is based on Market Value, then it must also be based on the Highest and Best Use of the real property.

• For mortgage valuations of improved residential property in the US, the appraisal is most often reported on a standardized form, such as the Uniform Residential Appraisal Report.

Price versus value

A price obtained for a specific property under a specific transaction may or may not represent that property's market value: special considerations may have been present, such as a special relationship between the buyer and the seller, or else the transaction may have been part of a larger set of

transactions in which the parties had engaged. Another possibility is that a special buyer may have been willing to

pay a premium over and above the market value, if his subjective valuation of the property (its investment value for him) was higher than the Market Value. An example of this would be the owner of a neighbouring property who, by combining his own property with the subject property, could thereby obtain economies-of-scale.

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Such situations often arise in corporate finance, as for example when a merger or acquisition is concluded at a price which is higher than the value represented by the price of the underlying stock. The usual rationale for these valuations would be that the 'sum is greater than its parts', since full ownership of a company entails special privileges for which a potential purchaser would be willing to pay.

Similarly, such situations arise in real estate/property markets as well. It is the task of the real estate appraiser/property valuer to judge whether a specific price obtained under a specific transaction is indicative of Market Value.

Different types of “value”

• There are several types and definitions of value sought by a real estate appraisal. Some of the most common are:

• Market Value – The price at which an asset would trade in a competitive Walrasian auction setting. Market Value is usually interchangeable with Open Market Value or Fair Value. International Valuation Standards (IVS) define Market Value as:

• Market Value is the estimated amount for which a property should exchange on the date of valuation between a willing buyer and a willing seller in an arms-length transaction after proper marketing wherein the parties had each acted knowledgeably, prudently, and without compulsion.

• Value-in-use – The net present value (NPV) of a cash flow that an asset generates for a specific owner under a specific use. Value-in-use is the value to one particular user, and is usually below the market value of a property.

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• Investment value - is the value to one particular investor, and is usually higher than the market value of a property.

• Insurable value - is the value of real property covered by an insurance policy. Generally it does not include the site value.

• Liquidation value -- may be analysed as either a forced liquidation or an orderly liquidation and is a commonly sought standard of value in bankruptcy proceedings. It assumes a seller who is compelled to sell after an exposure period which is less than the market-normal timeframe.

Value and Worth

• In Economics the ratio of the perceived value of a capital asset vis-a-vis its intrinsic risk of acquisition is termed 'worth'.

• `Clearly the lower the risk, the higher the worth. • It follows, therefore, that the perceived value - or simply

'value' - of a real capital asset is the total monetary worth obtained by reducing exposure to risk and liability.

• Put in elementary terms, 'value' is the total net benefit a buyer expects to receive from a purchase, measured in currency.

• The measure of the 'value in exchange' of the real estate transaction is the sales price.

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• In an economically efficient free market, defined as a market where there are large numbers of rational, profit-maximizers actively-competing participants, with each trying to predict future market values of individual investments and where important current information is almost freely available to all participants, competition leads to a situation where, at any point in time, actual sales prices will be a good estimate of value. It follows, therefore, that sales prices of transactions past are the best measure of value of transactions to come.

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• Real Estate, however, is possibly the inefficient market because different participants may have varying amounts, degree and quality of information.

• This offers an advantage to sellers and helps explain the reason why properties offered for sale are typically overpriced.

• Furthermore, the uniqueness of each property compounds such inefficiency even further.

• A problem, therefore, arises as it relates to the determination of value, and the solution is in function of the real capital asset taken into consideration.

Approaches to appraisal of R.E

1• The cost approach

2• The sales comparison approach

3• The income capitalization approach

The cost approach

• The cost approach was formerly called the summation approach.

• The theory is that the value of a property can be estimated by summing the land value and the depreciated value of any improvements.

• The value of the improvements is often referred to by the abbreviation RCNLD (reproduction cost new less depreciation or replacement cost new less depreciation). Reproduction refers to reproducing an exact replica. Replacement cost refers to the cost of building a house or other improvement which has the same utility, but using modern design, workmanship and materials. In practice, appraisers use replacement cost and then deduct a factor for any functional disutility associated with the age of the subject property.

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• In most instances when the cost approach is involved, the overall methodology is a hybrid of the cost and sales comparison approaches. For example, while the replacement cost to construct a building can be determined by adding the labour, material, and other costs, land values and depreciation must be derived from an analysis of comparable data.

• The cost approach is considered reliable when used on newer structures, but the method tends to become less reliable for older properties. The cost approach is often the only reliable approach when dealing with special use properties (e.g. -- public assembly, marinas).

The sales comparison approach

• The sales comparison approach in a real estate appraisal is based primarily on the principle of substitution.

• This approach assumes a prudent individual will pay no more for a property than it would cost to purchase a comparable substitute property.

• The approach recognizes that a typical buyer will compare asking prices and seek to purchase the property that meets his or her wants and needs for the lowest cost.

• In developing the sales comparison approach, the state licensed real estate appraiser attempts to interpret and measure the actions of parties involved in the marketplace, including buyers, sellers, and investors.

Steps in the Sales Comparison Approach

1. Research the market to obtain information pertaining to sales, listings, pending sales that are similar to the subject property. 2. Investigate the market data to determine whether they are factually correct and accurate.3. Determine relevant units of comparison (e.g., sales price per square foot), and develop a comparative analysis for each. 4. Compare the subject and comparable sales according to the elements of comparison and adjust as appropriate. 5. Reconcile the multiple value indications that result from the adjustment of the comparable sales into a single value indication.

The income capitalization approach

• Referred to simply as the "income approach“ is used to value commercial and investment properties. Because it is intended to directly reflect or model the expectations and behaviours of typical market participants, this approach is generally considered the most applicable valuation technique for income-producing properties, where sufficient market data exists to supply the necessary inputs and parameters for this approach.

• In a commercial income-producing property this approach capitalizes an income stream into a value indication.

• This can be done using revenue multipliers or capitalization rates applied to the first-year Net Operating Income.

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• The Net Operating Income (NOI) is gross potential income (GPI), less vacancy and collection loss (= Effective Gross Income) less operating expenses (but excluding debt service, income taxes, and/or depreciation charges applied by accountants).

• Alternatively, multiple years of net operating income can be valued by a discounted cash flow analysis (DCF) model. The DCF model is widely used to value larger and more expensive income-producing properties, such as large office towers. This technique applies market-supported yields (or discount rates) to future cash flows (such as annual income figures and typically a lump reversion from the eventual sale of the property) to arrive at a present value indication

Conclusion

As new data and business process standards are developed, appraisers must adapt to those standards, using these standards how every appraiser can meet the needs of a dynamically changing market - both domestically and globally - in real time.