Using Appraisals to Determine Market Value
Understanding Appraisals and Market Value
In the US, appraisals are performed to a certain standard of value (e.g. — foreclosure value, fair market value, distressed sale value, investment value). The most commonly used definition of value is Market Value. While the Uniform Standards of Professional Appraisal Practice (USPAP) does not define Market Value, it provides general guidance for how Market Value should be defined:
…a type of value, stated as an opinion, that presumes the transfer of a property (i.e., a right of ownership or a bundle of such rights), as of a certain date, under specific conditions set forth in the definition of the term identified by the appraiser as applicable in an appraisal.
Thus, the definition of market value used in an appraisal analysis and report is based on assumptions about the market in which the given property is for sale. It becomes the basis for selecting comparable data for use in the analysis. These assumptions will vary from definition to definition but generally fall into three categories:
- The relationship, knowledge, and motivation of the parties (i.e., seller and buyer);
- The terms of sale (e.g., cash, cash equivalent, or other terms); and
- The conditions of sale (e.g., exposure in a competitive market for a reasonable time prior to sale).
In the US, the most common definition of Market Value is the one promulgated for use in Federally regulated residential mortgage financing:
The most probable price which a property should bring in a competitive and open market under all conditions requisite to a fair sale, the buyer and seller, each acting prudently, knowledgeably and assuming the price is not affected by undue stimulus. Implicit in this definition is the consummation of a sale as of a specified date and the passing of title from seller to buyer under conditions whereby: (1) buyer and seller are typically motivated; (2) both parties are well informed or well advised, and each acting in what he or she considers his or her own best interest; (3) a reasonable time is allowed for exposure in the open market; (4) payment is made in terms of cash in U. S. dollars or in terms of financial arrangements comparable thereto; and (5) the price represents the normal consideration for the property sold unaffected by special or creative financing or sales concessions granted by anyone associated with the sale.
Three Approaches to Value
There are three general methods for determining value. These are usually referred to as the “three approaches to value”:
- The cost approach
- The sales comparison approach and
- The income approach
The appraiser using three approaches will determine which one or more of these approaches may be applicable, based on the scope of work determination, and from that develop an appraisal analysis. Costs, income, and sales vary widely from one situation to the next, and particular importance is given to the specific characteristics of the subject. Consideration is also given to the market for the property appraised. Appraisals of properties that are typically purchased by investors may give greater weight to the income approach, while small retail or office properties, often purchased by owner-users, may give greater weighting to the sales comparison approach. While this may seem simple, it is not always obvious. For example, apartment complexes of a given quality tend to sell at a price per apartment, and as such the sales comparison approach may be more applicable. Single family residences are most commonly valued with greatest weighting to the sales comparison approach, but if a single family dwelling is in a neighborhood where all or most of the dwellings are rental units, then some variant of the income approach may be more useful.
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 combining 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 of the exisiting property. 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.
In most instances when the cost approach is involved, the overall method is a combination of the cost and sales comparison approaches. For example, while the replacement cost to construct a building can be determined by adding the labor, 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 examines the price or price per unit area of similar properties being sold in the marketplace. Simply put, the sales of properties similar to the subject property are analyzed and the sale prices adjusted to account for differences in the comparables to the subject property to determine the value of the subject property. This approach is generally considered the most reliable if adequate comparable sales exist. In any event, it is the only independent check on the reasonability of an appraisal opinion.
Note that this approach develops value from a pricing scheme, and as such is an example of a revealed preference model. It relies on subjective human estimation as compared with that obtained by purely mathematic modeling.
The Income Capitalization Approach
The income capitalization approach (often 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 behaviors 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. 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.
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