Real Estate Appraiser's Reviewer - Part 2 of 3

[Advance Knowledge for Brokers]
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What are the guiding principles in valuation?

Principles of real estate MARKETABILITY

• § Principle of substitution. This states that a prudent buyer will pay no more for a property than the cost of a substitute property that will provide equivalent usefulness.
• § Principle of conformity
• § Principle of progression and regression
• § Principle of change. This states that the real estate market is dynamic rather than static; socio-economic forces are constantly changing, causing constant changes in value. Thus, market value today may not be the same as market value yesterday or tomorrow.
• § Principle of supply and demand
• § Principle of completion

Principles of real estate PRODUCTIVITY

• § Agents of production: land, labr, capital, coordination
• § The principle of contribution states that the value of a given feature of a property is worth only as much as the amount of money it contributes to the value of the property as whole. For example, improvements to property may add more, less, or as much value to the property as they cost, depending on what the market is willing to pay for the features.
• § The principle of increasing and decreasing/diminishing returns states that states that with each additional unit of improvement, the marginal utility of each unit declines until the point at which any additional units cost more than the additional value they add to the property.
• § This principle of “highest and best use” and consistent use states that the “highest and best use” of a property is the use that will bring the owner the highest economic benefit over the long run. Determining highest and best use is central to estimating market value because the use of a property for other than the current (or proposed) use may yield higher benefits to both the investor and the lender regarding greater investment returns and/or less risk than originally anticipated.
• § Principle of anticipation. This states that the property’s marker value is based on the investor’s expectation about the future benefits the property will provide and the present value of those benefits.

What is Replacement Cost?

§ It is the cost of replacing the property being appraised with that of another having equivalent utility and amenities.

What is Reproduction Cost?

§ It is the amount of money required for the exact reconstruction of the improvements being appraised similar to the original.

What is Depreciation?

• § For valuation purposes, depreciation is defined as a loss in value from any cause. It represent the difference in value between the building under appraisal and a new, substitute building.
• § Depreciation for valuation purposes is not in any way related to depreciation used in accounting sense or in income tax accounting.
• § Depreciation here can be in terms of physical depreciation or functional and economic obsolescence.

What are the different kinds of Depreciation?

• § Deterioration or the physical wearing out of the property. This is represented by normal wear and tear, the action of the elements and catastrophic events such as earthquakes, typhoons and fires.
• § Curable- if by treating the defects, the expected increase in value of the property will at least be more than the cost of treatment
• § Incurable- if the cost of treating the defect will be more than the expected increase in the property value
• § Functional obsolescence- or lack of desirability in terms of layout, style, and design as compared with that of a new property serving the same function. The loss in value from a decrease in functional utility due to technological improvements, new materials, and other innovations that make existing buildings obsolete for their original purpose.
• § Economic obsolescence- relating to loss of value from causes outside the property itself. The loss in value from forces external to the property such as the deterioration of a neighborhood, encroachments of such nuisances as noise and smell.

What are the basic approaches* to valuation?

Cost approach

• § The current cost of reproducing a property less depreciation from all source that is, deterioration, and functional and economic obsolescence

Income approach

• § The value which the property’s net earning power will support based upon a capitalization of net income

Market data approach

• § The value indicate by recent sales of comparable properties in the market

*The appraiser utilizes all three approaches in most of his appraisal work. He may believe that the value indicated by one approach will be more significant than that of the other two, yet he will use all three as a check against each other and to test his own judgment. However, there are appraisal problems in which they cannot be applied such as in vacant land, the use of the cost approach, or in the case of an owner-occupied home, the use of income approach. All three approaches are needed in the solution of most appraisal problems.

What is a Cost Approach in Real Estate Valuation?

§ In cost approach, the appraiser obtains a preliminary valuation by adding to his estimate of the land’s value, his estimate of the depreciated reproduction cost of the building and other improvements. This approach is based on the assumption that the reproduction cost is the upper limit of value. This also assumes that a newly constructed building would have advantages over the existing building as compared with the new building. The measure of this deficiency is called depreciation. For valuation purposes, depreciation is defined as a loss in value from any case. It represents the difference in value between the building under appraisal and a new, substitute building. Depreciation for valuation purposes is not in any way related to depreciation used in accounting sense or in income tax accounting.

What are the steps in Cost Approach?

• § The estimate of the land’s value as if it is vacant
• § The estimate of the current cost of reproduction of the existing improvements
• § The estimate and deduction of depreciation from all causes
• § The addition of the land’s value and the depreciated reproduction of improvements

What is Income Approach in Real Estate Valuation?

§ In income approach, the appraiser is concerned with the present worth of the future net income of a property which will be produced in its remaining economic life. This future net income is then capitalized by computing its present worth. Choosing what capitalization rate to apply is one of the most critical steps in the income approach. A variation of only one half of one percent can make a difference of many thousands of pesos in the capitalized value of the income.

What are the steps in income approach?

• § Obtaining the rent schedule and the percentage of occupancy for the subject property and for comparable properties for the current year and for several years in the past. This information provides gross rental and the trends in rental and occupancy. This data is then related and adjusted by the comparative method to ascertain the estimate of gross income which the subject property should produce to attract investors in the market.
• § Obtaining expense data such as taxes, insurance, and operating cost being paid by the subject property and by comparable properties. The trend in these expenses is also necessary.
• § Estimating the remaining useful economic life of the building to establish the probable duration of its income.
• § Selecting the appropriate capitalization rate and the applicable technique and methods for processing the net income.

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