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Monday, 11 June 2012

Real estate appraisal

Real estate appraisal, property valuation or land valuation is the process of valuing real property. The value usually sought is the property's Market Value. Appraisals are needed because compared to, say, corporate stock, real estate transactions occur very infrequently. Not only that, but every property is different from the next, a factor that doesn't affect assets like corporate stock. Furthermore, all properties differ from each other in their location - which is an important factor in their value. So a centralized Walrasian auction setting can't exist for the trading of property assets, such as exists to trade corporate stock (i.e. a stock market/exchange). This product differentiation and lack of frequent trading, unlike stocks, means that specialist qualified appraisers are needed to advise on the value of a property. The appraiser usually provides a written report on this value to his or her client. These reports are used as the basis for mortgage loans, for settling estates and divorces, for tax matters, and so on. Sometimes the appraisal report is used by both parties to set the sale price of the property appraised.

In some areas, an appraiser doesn't need a license or any certification to appraise property. Usually, however, most countries or regions require that appraisals are done 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.[1] Appraisals of more complex property (e.g. -- income producing, raw land) are usually reported in a narrative appraisal report.

UK valuation methods

In the United Kingdom, valuation methodology has traditionally been classified into five methods:

1. Comparative method. Used for most types of property where there is good evidence of previous sales. This is analogous to the sales comparison approach outlined above.

2. Investment method. Used for most commercial (and residential) property that is producing future cash flows through the letting of the property. If the current Estimated Rental Value (ERV) and the passing income are known, as well as the market-determined equivalent yield, then the property value can be determined by means of a simple model. Note that this method is really a comparison method, since the main variables are determined in the market. In standard US practice, however, the closely related capitalizing of NOI is confounded with the DCF method under the general classification of the income capitalization approach (see above).

3. Residual method. Used for properties ripe for development or redevelopment or for bare land only.

4. Profit method. Used for trading properties where evidence of rates is slight, such as hotels, restaurants and old-age homes. A three-year average of operating income (derived from the profit and loss or income statement) is capitalized using an appropriate yield. Note that since the variables used are inherent to the property and are not market-derived, therefore unless appropriate adjustments are made, the resulting value will be Value-in-Use or Investment Value, not Market Value.

5. Cost method. Used for land and buildings of special character for which profit figures cannot be obtained or land and buildings for which there is no market because of their public service or heritage characteristics. Both the residual method and the cost method would be grouped in the US under the cost approach (see above).

Under the current RICS Valuation Standards, the following bases of value are recognized:

    Market Value (see PS 3.2);
    market rent (see PS 3.3);
    worth (investment value) (see PS 3.4); and
    fair value (see PS 3.5)

Further considerations
Scope of work

While USPAP has always required appraisers to identify the scope of work needed to produce credible results, it became clear in recent years that appraisers did not fully understand the process for developing this adequately. In formulating the scope of work for a credible appraisal, the concept of a limited versus complete appraisal and the use of the Departure Rule caused confusion to clients, appraisers, and appraisal reviewers. In order to deal with this, USPAP was updated in 2006 with what came to be known as the Scope of Work project. Following this, USPAP eliminated both the Departure Rule and the concept of a limited appraisal, and a new Scope of Work rule was created. In this, appraisers were to identify six key parts of the appraisal problem at the beginning of each assignment:

    Client and other intended users
    Intended use of the appraisal and appraisal report
    Definition of value (e.g., market, foreclosure, investment)
    Any hypothetical conditions or extraordinary assumptions
    The effective date of the appraisal analysis
    The salient features of the subject property

Based on these factors, the appraiser must identify the scope of work needed, including the methodologies to be used, the extent of investigation, and the applicable approaches to value. Currently, minimum standards for scope of work are:

    Expectations of the client and other users
    The actions of the appraiser's peers who carry out similar assignments

The Scope of Work is the first step in any appraisal process. Without a strictly defined Scope of Work an appraisal's conclusions may not be viable. By defining the Scope of Work, an appraiser can properly develop a value for a given property for the intended user, and for the intended use of the appraisal. The whole idea of "Scope of Work" is to provide clear expectations and guidelines for all parties as to what the appraisal report does, and doesn't, cover; and how much work has gone into it.
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Types of ownership interest

 The type of real estate "interest" that is being valued, must also be known and stated in the report. Usually, for most sales, or mortgage financings, the fee simple interest is being valued. The fee simple interest is the most complete bundle of rights available. However, in many situations, and in many societies which do not follow English Common Law or the Napoleonic Code, some other interest may be more common. While there are many different possible interests in real estate, the three most common are:

    Fee simple value (known in the UK as freehold) - The most complete ownership in real estate, subject in common law countries to the powers reserved to the state (taxation, escheat, eminent domain, and police power)

    Leased fee value - This is simply the fee simple interest encumbered by a lease. If the lease is at market rent, then the leased fee value and the fee simple value are equal. However, if the tenant pays more or less than market, the residual owned by the leased fee holder, plus the market value of the tenancy, may be more or less than the fee simple value.

    Leasehold value - The interest held by a tenant. If the tenant pays market rent, then the leasehold has no market value. However, if the tenant pays less than market, the difference between the present value of what is paid and the present value of market rents would be a positive leasehold value. For example, a major chain retailer may be able to negotiate a below-market lease to serve as the anchor tenant for a shopping center. This leasehold value may be transferable to another anchor tenant, and if so the retail tenant has a positive interest in the real estate.
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Highest and best use

Highest and best use, or highest or best use (HBU), is a concept in real estate appraisal that shows how the highest value for a property is arrived. In any case where the market value of real property is sought, that value must be based on its highest and best use. Highest and best use is always that use that would produce the highest value for a property, regardless of its actual current use. The Appraisal Institute of Canada defines highest and best use as this:

    HIGHEST AND BEST USE: the reasonably probable and legal use of property, that is physically possible, appropriately supported, and financially feasible, and that results in the highest value.

The prior quotation shows that there are a series of tests which any proposed or theoretical use of a property must pass, before it can be the highest and best use of the property.

In some cases, a proposed use might be the highest and best use but for some cost that changes the net economics. An example might be an industrially-used site that is now legal for highrise residential buildings. However, the cost to clean up (remediate) the site is so expensive that the value as currently used is higher. In that case, if it can be continued, the existing industrial use would likely be the highest and best use.

In some cases, appraisers are given specific instructions as to an assumed highest and best use. This use might not pass the tests discussed below as a legitimate highest and best use and may very well produce a different value. One example of this might be a parkland valuation, where the appraiser has been instructed to ignore all other possible uses.

Vacant and improved

The Test of Highest and Best Use is applied to an improved properties both as improved and as if vacant. Vacant properties are generally only given the as vacant test. The Highest and Best Use as vacant may be the same or different as the Highest and Best use as improved.

For example, house A in a residentially zoned area may have a highest and best use as vacant and a highest and best use as improved that are both residential. A similar house B in a commercially zoned area may have a highest and best use as vacant as a commercial lot and highest and best use as improved as a single family residence.

If the value of the commercial lot as vacant in "House B" exceeds the value of house as a residence as improved plus demolition costs, the overall highest and best use of this property would be the as vacant value of the commercial lot. For example, assume that "House B" has a value as a house of $200,000, and a site value as a commercial lot of $250,000 with a cost to demolish the house and prepare the site at $25,000. The highest and best use of the site is to demolish the house and sell the site as a commercial lot. The market value would be $225,000 ($250,000 site value minus $25,000 demolition cost). However, if the demolition costs rose to $55,000, the highest and best use would be the existing residential use, because the value as a commercial lot (now $195,000) would not exceed the existing value as a residence.

This would be the highest and best use of the property, even though it is contrary to what actually exists.Even if the house is not razed and the site sold as a commercial lot, the highest and best use is the commercial lot use. The market value of the property is driven by this hypothetical conversion, even if it never takes place due to the utility that this potential conversion would bring to a purchaser.
Economic theory

The economic concepts of utility and substitution drive the highest and best use analysis. The highest and best use of a property determines its utility to a potential purchaser. The purchaser of such a property would pay no more than a competing property with the same utility while a seller would accept no less than a seller of a comparable property. That is true to the neighborhood.
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