Test 6: Economics; Appraisal

demand for the item is increasing in relation to supply of the item.

In a market economy, the primary interactions between supply, demand and price are: if supply increases relative to demand, price decreases; if supply decreases relative to demand, price increases; if demand increases relative to supply, price increases; and if demand decreases relative to supply, price decreases.

Supply and demand are equal, and price and value are equal.

A market tends toward a state of equilibrium in which supply equals demand, and price, cost, and value are identical. According to this principle, market demand moves to meet supply, and supply moves to meet demand. If there is an extreme shortage of an item for which there is normally a strong demand, suppliers will rush to increase production to close the gap. If inventories of an item are very high, suppliers will stop production until the oversupply has been depleted.

the uniqueness of every parcel.

In comparison with other economic products and services, real estate has certain unique traits. Traits of real estate include: inherent product value; uniqueness of every property; demand must come to the supply; illiquidity; slow to respond to changes; and a decentralized local market.

Prices rise.

If demand is increasing and a moratorium slows supply, demand will begin to outpace supply, forcing prices to rise as the product becomes scarcer in relation to demand.

an increase in demand for all types of real estate.

New businesses will arise to support the new company. They will hire new employees, some from out of town. The new employees will need housing. Hence the demand for residential real estate, as well as for commercial and industrial, will intensify, and it will also stimulate new construction.

The number of available units that become occupied over a period of time.

Absorption is the amount of available property that becomes occupied over a period of time.

rising prices.

Within the business cycle of real estate, declining vacancy indicates a combination of increasing demand which ‘fills up’ supply which in turn decreases. As space becomes scarcer, rents for available space increase.

desire, utility, scarcity, and purchasing power.

The value of something is based on the answers to four questions: how much do I desire it; how useful is it; how scarce is it; and am I able to pay for it.

will increase.

If there is no longer a supply to meet the increasing demand of a growing population, prices for existing supply will rise.

the market tending toward equilibrium.

A market tends toward a state of equilibrium in which supply equals demand, and price, cost, and value are identical. Thus if supply is scarce, construction will increase to stabilize the imbalance.

the market is over-supplied.

Falling prices indicate an oversupply of commercial properties in relation to demand. In this case, construction of new supply will also slow down.

have been increasing.

A rise in prices is a market signal that there is an undersupply of product in relation to demand. As the market moves toward equilibrium, builders construct more buildings to meet the unmet demand.

It is often difficult to convert to cash.

Since real estate is often a large, long-term investment that has no exact duplicate, the process of a buyer’s evaluating and choosing the right property is long and complex; hence, finding a buyer at a desired price can take a long time.

The number of persons employed in base industries in an area

Base employment is the number of persons employed in the base industries that represent the economic foundation of an area. It is the driving component of total employment, which includes secondary and support industries, and which creates demand for all types of real estate.

The total existing space of a certain type that is unoccupied at a given time

Vacancy is the amount of total real estate inventory of a certain type that is unoccupied at a given time. It is often stated as a percentage of total inventory, the vacancy rate for that property type.

local government influencing the real estate market, regardless of demand.

Local governments sometimes declare a moratorium on new construction because of present or projected inadequacies of the infrastructure—water, sewer, power, roads, etc.—or because of the desire to conform to a master plan. The result may be to drive up prices, as supply cannot freely increase to meet demand.

In- and out-migrations of major employers

Changes in employment numbers in a local market area, especially in major industries, have a direct impact on real estate demand in the area. Money supply, interest rates, and trade imbalances also have an impact, but they are regional or national factors rather than strictly local.

Vacancy rises and prices fall.

New construction generally occurs to meet an excess of demand. By adding supply, it tends to increase vacancy and lower prices until supply-demand equilibrium is achieved.

Residential

While all types of users may have these needs, they are most prominent for residential users because of concerns for family comfort and safety. Retail users are more concerned with competitive features of the trade area; office users care more about occupancy costs and suitability for the business; industrial users care more about such features as functionality, accessibility, and the labor pool.

its susceptibility to swings in the local economy.

Because a real property cannot be transferred to a large, central real estate marketplace, its marketability is closely tied to local conditions. Investors and users must come to the product, unlike other types of economic product that can be moved to a place in search of greater demand.

anticipation.

Anticipation is the value principle that a buyer will pay a price based on the benefits the buyer expects to derive from a property over a holding period. For example, if an investor anticipates an annual rental income from a leased property to be one million dollars, this expected sum has a direct bearing on what the investor will pay for the property.

A homeowner adds a third bathroom to a house and thereby increases the appraised value by $10,000.

The principle of contribution focuses on the degree to which a particular improvement affects market value of the overall property. In essence, the contribution of the improvement is equal to the change in market value that the addition of the improvement causes. For example, adding a bathroom to a house may contribute an additional $15,000 to the appraised value. Thus the contribution of the bathroom is $15,000.

assemblage.

Assemblage, or the conjoining of adjacent properties, sometimes creates a combined value that is greater than the values of the unassembled properties. The excess value created by assemblage is called plottage value.

Market value is an estimate; market price is the price at which a property sold.

Market value is an estimate of the price at which a property will sell at a particular time. The market price, as opposed to market value, is what a property actually sells for. Market price should theoretically be the same as market value if all the conditions essential for market value are present. Market price, however, may not reflect the analysis of comparables and of investment value that an estimate of market value includes.

define the appraisal problem and the purpose of the appraisal.

The first step in the process is to define the appraisal problem and the purpose of the appraisal. This involves identifying the subject property by legal description; specifying the interest to be appraised; specifying the purpose of the appraisal; specifying the date for which the appraisal is valid; and identifying the type of value to be estimated.

weighing the applicability of the approaches and considering the quality of data supporting each approach.

The final step in the appraisal process is to reconcile the value estimates produced by the three approaches to value into a final value estimate. To do this, an appraiser must weigh the appropriateness of a particular approach to the type of property being appraised and take into account the quality and quantity of data obtained in each method.

Make dollar adjustments to the sale prices of comparable properties to account for competitive differences with the subject.

The sales comparison approach consists of comparing sale prices of recently sold properties that are comparable with the subject, and making dollar adjustments to the price of each comparable to account for competitive differences with the subject. After identifying the adjusted value of each comparable, the appraiser weights the reliability of each comparable and the factors underlying how the adjustments were made. The weighting yields a final value range based on the most reliable factors in the analysis.

takes into account the competitive value of specific amenities of the subject property.

The sales comparison approach is widely used because it takes into account the subject property’s specific amenities in relation to competing properties. In addition, because of the currency of its data, the approach incorporates present market realities.

adds value to a comparable that is inferior to the subject property.

If the comparable is inferior to the subject in some characteristic, an amount is added to the price of the comparable. If the comparable is better than the subject in some characteristic, an amount is deducted from the sale price of the comparable. This neutralizes the comparable’s competitive advantage or disadvantage in an adjustment category. For example, a comparable has a swimming pool and the subject does not. To equalize the difference, the appraiser deducts an amount, say $6,000, from the sale price of the comparable.

requires the fewest and smallest adjustments.

$395,000.

Since the comparable has an extra bath, it is adjusted downward to equalize with the subject. Conversely, since it has no patio, the appraiser adds value to the comparable. Thus, $400,000 minus $7,000 plus $2,000 equals $395,000.

Add the estimated land value and cost of improvements and subtract the accrued depreciation of the improvements.

The cost approach consists of estimating the value of the land ‘as if vacant;’ estimating the cost of improvements; estimating and deducting accrued depreciation; and adding the estimated land value to the estimated depreciated cost of the improvements.

is very accurate for a property with new improvements that represent the highest and best use.

The strengths of the cost approach are that it: provides an upper limit for the subject’s value based on the undepreciated cost of reproducing the improvements. It is also very accurate for valuing a property with new improvements which are the highest and best use of the property.

a property loses the same increment of value each year over the economic life of the property.

All property improvements have an economic life, which becomes incrementally shorter year after year as physical deterioration takes its toll. The property as a whole does not lose value, since land itself does not depreciate. Similarly, an improvement can regain value if it is repaired or updated. Finally, not all properties lose value from economic obsolescence.

$575,000.

To appraise value using the cost approach, add the land value to the value of the depreciated improvement. Thus you have $150,000 + ($475,000 – 50,000), or $575,000.

Divide the income a property generates by a rate of return.

An appraiser obtains an indication of value from the income capitalization method by dividing the estimated net operating income for the subject by the rate of return, or capitalization rate. The formula is: NOI / Cap rate = Value.

uses a method that is also used by investors to determine how much they should pay for an investment property.

The strength of the income approach is that it is used by investors themselves to determine how much they should pay for a property. Thus, in the right circumstances, it provides a good basis for estimating market value. The approach, however, does not project what an income property’s future income will be. Moreover, it is not an applicable method for estimating value if the subject is a non-income producing property.

$370,000.

First, identify net income by subtracting out vacancy and expenses. Then divide by the capitalization rate. Thus, ($60,000 –3,000 – 20,000) ÷ 10% = $370,000.

150.

$406,000.

Multiply the monthly gross income times 12 to derive annual income. Multiply annual income times the gross income multiplier to derive the estimate of price. Thus, $2,400 times 12 equals $28,800. This times 14.1 equals $406,080, or $406,000 rounded.

the state in which the appraiser operates.

A state-certified appraiser is one who has passed the necessary examinations and competency standards as established by each state in conformance with the federal standards.

The Financial Institutions Reform, Recovery and Enforcement Act (FIRREA).

Title XI of FIRREA requires that competent individuals whose professional conduct is properly supervised perform all appraisals used in federally-related transactions. As of January 1, 1993, such federally-related appraisals must be performed only by state-certified appraisers.

if two similar properties are for sale, a buyer will purchase the cheaper of the two.

According to the principle of substitution, a buyer will pay no more for a property than the buyer would have to pay for an equally desirable and available substitute property. For example, if three houses for sale are essentially similar in size, quality and location, a potential buyer is unlikely to choose the one that is priced significantly higher than the other two.

is physically and financially feasible, legal, and the most productive.

This valuation principle holds that there is, theoretically, a single use for a property that produces the greatest income and return. A property achieves its maximum value when it is put to this use. The use must however be legal.

(d) $400,000.

Market value is an opinion of the price that a willing seller and willing buyer would probably agree on for a property at a given time if: the transaction is for cash; the property is exposed on the open market for a reasonable period; buyer and seller have full information about market conditions ; there is no abnormal pressure on either party; it is an ‘arm’s length’ transaction; title is marketable; and the price does not include hidden influences such as special financing deals. The amount Lynne actually paid is the market price. The previous listing price and Ken’s offer might be interesting data for the appraiser, but the appraisal must also consider other market data, such as comparable sales.

there may be no recent sale price data in the market.

The sales comparison approach is limited in that every property is unique. As a result, it is difficult to find good comparables, especially for special-purpose properties. In addition, the market must be active; otherwise, sale prices lack currency and reliability.

selects comparable properties, adjusts the comparables, and estimates the value.

The steps are to first identify comparable sales; then compare comparables to the subject and make adjustments to comparables; then, finally, weigh values indicated by adjusted comparables for the final value estimate of the subject.

replacement cost.

Reproduction cost is the cost of constructing, at current prices, a precise duplicate of the subject improvements. Replacement cost is the cost of constructing, at current prices and using current materials and methods, a functional equivalent of the subject improvements.

estimates depreciation, subtracts depreciation from cost, and adds back the land value.

The steps in the costs approach are: (1) estimate land value; (2) estimate reproduction or replacement cost of improvements; (3) estimate accrued depreciation; (4) subtract accrued depreciation from reproduction or replacement cost; and (5) add land value to depreciated reproduction or replacement cost.

market value is not always the same as what the property cost.

The limitations of the cost approach are that: the cost to create improvements is not necessarily the same as market value; and depreciation is difficult to measure, especially for older buildings

incurable economic obsolescence.

Economic (or external) obsolescence is the loss of value due to adverse changes in the surroundings of the subject property that make the subject less desirable. Since such changes are usually beyond the control of the property owner, economic obsolescence is considered an incurable value loss.

depreciation.

Depreciation is the loss of value in an improvement over time. The loss of an improvement’s value can come from any cause, such as deterioration, obsolescence, or changes in the neighborhood.

the seller offers below-market seller financing.

The principal factors for comparison and adjustment are time of sale, location, physical characteristics, and transaction characteristics. An adjustment may be made for such differences as mortgage loan terms, mortgage assumability, and owner financing.

functional obsolescence.

Functional obsolescence occurs when a property has outmoded physical or design features which are no longer desirable or acceptable to current users.

weights the comparables.

The last step in the approach is to perform a weighted analysis of the indicated values of each comparable. The appraiser, in other words, must identify which comparable values are more indicative of the subject and which are less indicative. However, all comparables are taken into account, not simply the nearest comparable.