Resources for Lenders, Community Bankers & Finance Professionals

Anyone involved in real estate lending should understand the basics of real estate appraisals and their limitations. The real estate market is imperfect because all properties are unique. Even condominiums in the same projects may have different floor plans, views, parking, etc. These features make an exact valuation impossible. The closest we as lenders can get is an approximation of value. This valuation process is called an appraisal if it is performed by a qualified professional.

 

Appraisers use three primary valuation processes: cost approach, market comparison approach and income approach. They then weigh each of these valuation processes to come up with a final value, called the appraised value. An appraisal includes a property description, the appraisers opinion of the property condition, its utility for a given purpose, and its probable value on the open market.

 

The Appraisal Process

 

1. State the Problem

2. List the data needed and the source of that information

3. Gather, record and verify the relevant data, including national,             regional, and local information on the real estate market.

4. Specify information regarding the site and improvements. Include       data required for each of approaches: cost data, sales     data and       income and expense data.

5. Determine the Highest and Best Use for the Property

6. Estimate the land value

7. Estimate the property value under each of the three approaches

8. Reconcile each value under the three approaches for a final value       estimate

9. Report the Final Value Estimate

 

Cost Approach

 

In the cost approach, the appraiser estimates the value of any improvements (buildings, parking, etc.) to the land in terms of their replacement or reproduction costs as if they were new. The appraiser then subtracts any loss in value due to depreciation of these improvements (note: land does not depreciate). The estimated value of the land is then added to the value of the improvements: Replacement or Reproduction Costs of Improvements -Depreciation of Improvements + Land Value (obtained from sales comparison approach) = Property Value under Cost Approach

 

When using the cost approach, it is important to realize the importance of depreciation, which is either physical or functional. Physical depreciation is the wear-and-tear or deterioration of improvements. Functional Depreciation, more aptly called functional obsolescence is caused by factors outside the property, such as changes in preferences (layouts), traffic patterns, zoning, etc.

 

Market Data (Sales Comparison) Approach

 

The Market Data or Sales Comparison Approach to appraising makes the most direct use of the principal of substitution. The appraiser locates three or more properties that have recently sold and have similar attributes to the subject property. The appraiser reviews these properties and makes adjustments for any dissimilar features. For instance, if the similar property had a dock (waterfront) and the subject property does not, the similar properties value would be adjusted downward by the estimated value of the dock. The opposite holds true; the appraiser will add to the sales price of the comparable property the value of the feature present in the subject property, but not in the comparable.

 

Income (Income Capitalization) Approach

 

The income approach value is based on the net income, or investment return, that a buyer expects from the property. The price that an investor is willing to pay for a property is based on the expected return from the property. Two properties with different projected income streams will have two different values under the income comparison approach, even if they cost an identical amount to build. The lender should be aware that the income comparison approach deducts the operating costs from the rental or lease revenue to derive a Net Operating Income (NOI). These are only operating expenses and not financing expenses, as everyone theoretically has their own borrowing rate based upon their unique factors. NOI provides a common point of comparison.

 

Rental (or Lease) Income - Operating Expenses (maintenance, real estate taxes, insurance) = Net Operating Income

 

A rate of return or Capitalization Rate is then applied to the NOI to come up with a Value for the Property.

 

Net Operating Income/Return(Capitalization) = Property Value

 

There are four classes of expenses that are classified as expenses for accounting purposes that are not included in determining Net Operating Income (NOI):

 

1. Financing Costs

2. Income Tax Payments

3. Depreciation Expense

4. Capital Improvements

 

Final Value

 

Most appraisals require the use of more than one of these approaches. In general, the Market Data Approach is the most reliable approach for single-family residences, the Cost Approach is most reliable for non-income producing properties that have a limited market, and the Income Approach is most reliable for income producing properties.

 

In reconciling the final value for an appraisal, the appraiser considers at the following factors:

 

1. Definition of the value sought;

2. The amount and reliability of the data sought under each                       approach;

3. The strengths and weaknesses of each approach relative to the           property being appraised; and

4. and market behavior relative to the subject property.

 

The appraiser never averages the different approaches. The approaches are weighted according to their relevance to the subject property. Accordingly, the Income Approach will have a much higher weight for income properties and no weight for a limited purpose non-income producing property. In general, the different approaches can provide a check to each other.

 

Highest and Best Use

 

Every appraisal includes a statement regarding the highest and best use of the property, using the following four tests:

 

1. Physically possible (includes topography, shape and size                         considerations);

2. Legally permissible (complies with local, state and national                     regulations);

3. Economically feasible (Will the property provide an adequate               return for the funds being invested?)

4. Maximally productive (Do economics indicate that the property is       more profitable under a different use, at least in the present?).

 

Understanding Cap Rates

 

Investors who purchase income producing properties expect two things:

 

1. Return of Investment. This consists of the recapture of the                 original investment at the end of the term of ownership, which is         expressed as an annual rate. Appraisers commonly call this capital     recapture.

   

    Ex. Straight line Method: 100%/Years of Useful Life = Annual Recapture     Rate (This method requires a knowledge of the remaining given life of a     structure)

 

2. Return on Investment. The return is the investor's profit on the             money used to purchase the property. This rate is called the                 discount rate, risk rate of return and sometimes interest rate.

 

Other Capitalization Rate Methods:

 

Market Extraction Method - In this method, the appraiser finds the interest rate of comparable properties by subtracting the building recapture from the property's NOI, then dividing the remainder by the selling price of the building: For example, Property A sold for $400,000 and the site is valued at $100,000. The building has a remaining life of 40 years and it generates an NOI of $60,000.

 

Building Value = $400,000 (sales price) less $100,000 equals $300,000. The recapture rate is .025 (1 / 40 years = .025).

$300,000 (Bldg. Value) x .025 (Recapture Rate) = $7,500 = Annual Recapture

 

NOI - Annual Recapture = NOI available for return / Property Sales Price = Interest Rate or Discount Rate for property
$60,000 - $7,500 = $52,500 / $400,000 = .13125 = Interest Rate

 

Annual Recapture Rate + Interest Rate = Cap Rate
.025 + .13125 = 15.625 = Cap Rate

 

Band of Investment Method - This method weighs debt and equity required to support the investment; it takes into consideration the rate required by the lender and the pretax rate necessary for the investor to make the investment.

Debt: A $100,000 thirty year mortgage has monthly payments of $733.78, making annual debt service $8,805.36. The mortgage constant is $8,805.36 divided by $100,000, which is .088 or 8.8%.

 

The rate required by the equity investor is pretax cash flow divided by the investment. It is also called equity capitalization rate or cash on cash return

 

If the loan to purchase price of the property is 80%, that means the equity investor had to provide 20% equity into the transaction. By weighing each the following analysis can be made:

 

Loan = 80% x 8.8% (mortgage constant) = .07
Equity = 20% x 10% (equity cap rate) = .02
Overall Rate = .09 or 9%

 

The Relationship Between Capitalization Rate and Risk:

 

High Risk = High Capitalization Rate = Low Value
Low Risk = Low Capitalization Rate = High Value