What is MAI?

MAI is a professional designation for real estate appraisers who are experienced in the valuation and evaluation of commercial, industrial, residential, and other types of properties, and who advise clients on real estate nvestment decisions. Originally, the name of the organization was the American Institute of Real Estate Appraisers (AIREA) until it merged with the Society of Real Estate Appraisers (SREA) in the 1980s.

 

 

The current requirements that an appraiser must fulfill to receive the MAI designation are as follows:

• Education:

• Receive a passing grade on 11 examinations that reflect 380 hours of classroom instruction and that test the appraiser’s knowledge of basic and advanced appraisal principles, procedures and applications; report writing; valuation analysis and standards of professional practice
• Receive a passing grade on a four-module, two-day comprehensive examination
• Hold an undergraduate degree from a four-year accredited educational institution

• Experience: Receive credit for 4,500 hours of experience, all of which must meet strict criteria.

• Demonstration Report: Receive credit for a demonstration appraisal report relating to income-producing property that demonstrates the ability to present a properly supported value estimate or opinion evaluating the nature, quality or utility of a parcel of real estate or any interest in, or aspect of, real property, including handling physical incurable depreciation, or fulfill an approved comparable alternative.

 

 

USPAP

The profession of Appraisal has uniform standards to be followed by all practitioners.  The main guiding doctrine for appraisers is USPAP.  

 

What is USPAP?: The Uniform Standards of Professional Appraisal Practice, (USPAP), is considered the quality control standards applicable for real property, personal property, intangibles, and business valuation appraisal analysis and reports in the United States. USPAP was first developed in the 1980s by a joint committee representing the major U.S. and Canadian appraisal organizations. As a result of the savings and loan crisis, the Appraisal Foundation (TAF) was formed by these same groups, along with support and input from major industry and educational groups, and TAF took over administration of USPAP.

 

USPAP Standards: While USPAP provides a minimum set of quality control standards for the conduct of appraisal in the U.S., it does not attempt to prescribe specific methods to be used. Rather, USPAP simply requires that appraisers be familiar with and correctly utilize those methods which would be acceptable to other appraisers familiar with the assignment at hand and acceptable to the intended users of the appraisal. USPAP directs this through what is called the Scope of Work rule.

 

 

At the onset of an assignment, an appraiser is obligated to gather certain specified preliminary data about the project, such as the nature of the property to be appraised, the basis of value (e.g. market, investment, impaired, unimpaired), the interests appraised (e.g. fee, partial), important assumptions or hypothetical conditions, and the effective date of the valuation. Based on this and other key information, the appraiser relies on peer-reviewed methodology to formulate an acceptable workplan.

 

USPAP Updates:  Since 2006, USPAP has been updated in a 2 year cycle, which begins on January 1 of even number years. The current version of USPAP is available at www.appraisalfoundation.org and has an effective date of January 1, 2010.

 

 

Deriving Cap Rates

There are several acceptable methods for deriving capitalization rates for use in the income approach to property appraisal.  The following explains some of the more commonly used approached to cap rate derivation.

 

 

Direct Market Extraction: This approach simply obtains cap rates by examing the cap rates for sales comps.  It assumes that there is current, readily available net operating income and sale price information on comparable income-generating properties. The advantage with the market-extraction method is that the capitalization rate makes the direct income capitalization more meaningful.  The cap rates for the most recent and similar properties are given the most weight in this process.  Market cap rates may also be obtainined through interviews of appraisal professionals, brokers and investors.

 

 

Summation Technique: This approach combines market risk and reward measurements to obtain a cap rate.  For example, to obtain a cap rate, the following may be added together:

1) Expected Inflation Rate;

2) Real Rate of Return;

3) Risk Premium Rate; and,

4) Recapture Premium Rate. 

 

General Constant Growth Formula: Simply derives a capitalization rate by subtracting the growth rate of the economy from the IRR on equity.

 

(M x Rm) + (E x Re) = Ro

 

Band of Investment (Borrowing Cost & Rate of Return): This method presumes that a capitalization rate equates to a composite of debt and equity funds. This overall rate is extracted by deriving the weighted average of the mortgage capitalization rate and the equity capitalization rate. Market data components in this equation are the proportions of debt and equity in a typical deal and surveys of mortgage interest and equity return rates as well as actual market data for these components where available. The reliability of this method depends on the accuracy of the analyst's research and the disparity of rates between surveys and actual transactions.  The method derives an overall cap rate as follows: [(LTV x Mortgage Constant) + (ETV x required rate of return)]. 

 

Band of Investment (Land & Building): The band of investment calculation can be modified to incorporate land and building valuation metrics.  In so doing, the cap rate is derived as follows: [(Ratio of land value to total property value x Land Cap Rate) + (Ration of building value to total property value x Building Cap Rate)].

 

 

Discount Rate v. Cap Rate

Both the discount rate and the capitalization rate are applied in the appraisal process.  It is important that the difference between these rates be understood so that they are not incorrectly applied.

 

Discount Rate: Rate used to convert a specified future income stream for a given period + sales proceeds into a present value. It is the equivalent of the yield rate or IRR.

 

Captialization Rate: Determined by dividing the property's NOI by its sales price.  This rate incorporates the anticipation of income increasing or decreasing and the appreciation / depreciation of the subject property.

 

 

 

 

 

Discounted Cash Flow Model of Income Valuation

The discounted cash flow (DCF) model determines a properties value by discounting the following values to a present value:         

 

     1) NOI for all years through the end of the projected holding period for the property; and,

 

     2)  Sales proceeds for the property at the end of the projected holding period for the property.

 

 

     To properly apply this approach, the appraiser must develop a forecast of NOI for each year in the expected holding period.  If this information os not available from the property owner, it may be available for comparable properties.  Next, the appraiser will estimate the sales reversion at the end of the holding period.  The appraiser must then determine an appropriate discount rate -- this is typically done through an investor survey.  Finally, the appraiser will set up a T-Bar and solve for the present value of the differential NOI cash flows and reversion value of the property. 

Functional & External Obsolesence in the Cost Approach

Step 3 of the cost approach to valuation is to estimate the structure's accumulated depreciation. There are five forms of depreciation and value adjustments that should be considered.  Three of these adjustments involve functional and external obsolescence related to the subject property.

 

Curable Functional Obsolescence: Essentially this value adjustment acknowledges that design defects or obsolete components can create a loss of value.  For example, materials once considered acceptable when the structure was built may be considered sub-standard today.  The cost of bringing the obsolete components up to current standards should be calculated and subtracted from the building's replacement cost.  The follwoing example of adding an elevator to a building is instructive:

 

Cost of Widening Halls:                                     $15,000

Cost of Elevator:

             To install Today               $50,000

             To install at orig constr    $30,000

             Value Loss                                           $20,000

 

Total Curable Functional Obsolescence:         $35,000

 

 

Incurable Functional Obsolescence: Assume that a property needs a parking lot to compete in its marketplace.  If that property does not have the physical space to build a parking lot, obviously the condition cannot be cured. The resulting loss in value counts as incurable functional obsolescence.  To value incurable functional obsolescence, estimate the loss of net operating income (NOI) from the lack of the parking lot and divide the estimated NOI by properties capitalization rate to obtain lost value.

 

 

External Obsolescence: This value impairment is a function of forces beyond the property owner's control. For example, if an entire area where the subject property is located deteriorates due to lack of maintenance of common areas and roads, that is external obsolescence.  Likewise, if a new mall is built near a property and traffic congestion significantly increases to the point of impairing access to the property, this obsolescence is external to the property.  Any loss in value from external obsolescence is divided proportionally between the land and the improvements because both are affected by the outside influence.  

 

Curable & Incurable Physical Deterioration in the Cost Approach

Step 3 of the cost approach to valuation is to estimate the structure's accumulated depreciation.  There are five forms of depreciation and value adjustments that should be considered.  Two of these adjustments involve the calculation of curable and incurable physical deterioration of a structure.

 

Curable Physical Deterioration: Estimating the value to assign this component simply involves taking inventory of what needs repaired, such as weather stripping, painting, window replacement, etc., and assigning it a market cost to remedy.  This should only include items if the gain in value resulting from the repair will offset the cost of repair.

 

 

 

Incurable Physical Deterioration: The loss resulting from wear and tear for which the cost of repair would outweigh the increase in value from repair.  This includes ALL physical deterioration not included in the "curable" category.  Incurable physical deterioration is categorized into short-term and long-term.  Shoert term includes items with an expected life shorter than that of the building.  Long-term includes those items that have an expected life equal to or longer than the expected remaining life of the building.

Cost Approach: Methods for Estimating Direct & Indirect Replacement Costs

Three main methods are utilized for estimating structure replacement costs when using the cost approach.  They are 1) the comparative unit method; 2) the quantity survey method; and, 3) the unit in place method.

 

Comparative Unit Method:  This method is most effectively used when there is nothing particularly special about the building being appraised.  It is the easiest and most commonly used technique for estimating replacement costs.  To apply, the appraiser simply identifies the average cost per square foot (or cubic foot) to build a replacement structure and mulitplies by the number of square feet in the replacement structure.  Average cost information can usually be found in local tax district files or in national construction cost manuals such as Marshall & Swift, Boecha or S.W. Dodge.

 

 

Quantity Survey:  Looks much like a contractor's line item bid.  This method requires significant work and familiarity with construction techniques.  Quantity surveys are seldom used by assessors valuing old buildings. However, when the subject building has just been completed and the construction bids are still current, this method can produce very accurate estimates of replacement costs.

 

Unit-In-place Method: This method determines the unit cost of all building labor and materials and multiplies the sum by the amount actually used on the building.  For example, if painting the building's exterior costs $.30 psf, then the cost of painting 1,000 sf would be $300.  Unit costs of various components are usually based on information from local tax district files or construction cost manuals.

 

Effectiveness & Limitations of the Cost Approach

The cost approach to calculating appraisal value for land and property can be extremely effective in certain situations.  However, the cost approach does have limitations.

Effectiveness of the Cost Approach

For new construction, the cost appraoch can be uniquely instructive.  If the project is newly completed, then the contractor's line item lists of costs for labors and materials and indirect costs will be accurate.  Accordingly, it may be an extremely accurate estimation of market value.

 

Using the cost approach is most appropriate where the sales comparison approach cannot be utilized because of a lack of comparable data on comparable sales or rentals.

 

Furthermore, the cost approach is appropriate for use where the subject property is a special use building such as an oil refinery, museum or church.

Limitations of the Cost Approach

A major limitation of the cost approach is that it does not reflect the forces of supply and demand.

 

Further, when the degree of depreciation for the subject property is high and cannot be quantified with reliability, the results obtained from the cost appraoch are vulnerable to scrutiny and may not be reliable. 

Steps in Applying the Cost Approach

There are five steps in applying the cost approach to obtain an appraised value for property.  The steps are as follows:

1. Estimate the cost to reproduce the existing building as new and site improvements. 

2. Estimate all forms of depreciation.

3. Calculate the depreciated value of the property by subtracting the result of Step 2 from the value of Step 1.



4. Estimate the value of the site (land only), as if it were vacant using the sales comparison approach (assume site will be improved to its highest and best use).

5. Add the value of the site to the deprecited value of the improvements [step 3 + step 4].

The Cost Appraoch to Market Value (Introduction)

The cost approach to market value considers the cost of reproducing a property minus accrued depreciation plus the market value of the land.

 

 

Accrued depreciation comes from three sources:

 

1) physical deterioration;

2) functional obsolescence; and,

3) external obsolescence.

4 Steps in the Sales Approach to Value

 

 

The Sales Comparison Approach

 

This approach recognizes that a typical buyer will compare asking prices and seek to purchase the property that meets his or her wants and needs for the lowest cost. In developing the sales comparison approach, the appraiser attempts to interpret and measure the actions of parties involved in the marketplace, including buyers, sellers, and investors.

 

Data are collected on recent sales of properties similar to the subject being valued, called comparables. Only SOLD properties may be used in an appraisal and determination of a property's value. Sources of comparable data include real estate publications, public records, buyers, sellers, real estate brokers and/or agents, appraisers, and so on. Important details of each comparable sale are described in the appraisal report. Since comparable sales aren't identical to the subject property, adjustments may be made for date of sale, location, style, amenities, square footage, site size, etc. The main idea is to simulate the price that would have been paid if each comparable sale were identical to the subject property. If the comparable is superior to the subject in a factor or aspect, then a downward adjustment is needed for that factor. Likewise, if the comparable is inferior to the subject in an aspect, then an upward adjustment for that aspect is needed. From the analysis of the group of adjusted sales prices of the comparable sales, the appraiser selects an indicator of value that is representative of the subject property.

 

 

Steps in the sales comparison approach

 

1. Research the market to obtain information pertaining to sales, and pending sales that are similar to the subject property.

 

2. Investigate the market data to determine whether they are factually correct and accurate.

 

3. Determine relevant units of comparison (e.g., sales price per square foot), and develop a comparative analysis for each.

 

4. Compare the subject and comparable sales according to the elements of comparison and adjust as appropriate.

 

5. Reconcile the multiple value indications that result from the adjustment of the comparable sales into a single value indication.

HABU

The legal use of a property that will yield to the property its highest present value is the property's Highest And Best Use.  Four criteria must be analyzed in the Highest And Best Use evaluation:

1. Is use physically possible?

2. Is use legally possible?

3. Is it financially feasible?

4. Is it maximally productive?


 

Improved properties are analyzed for HABU both as if vacant and as improved.  The analysis of examining an improved property as vacant is designed to identify possible superior uses of the property.  The highest and best use as improved examins the improvements for adequacy for intended use and obsolescence.  Potential modifications to the improvements, which couls improve the property's financial return are then explored. 

Types of Value

In the appraisal of real estate there are many types of value that can be utilized.  Several of the most relevant value measurements are discussed below:

Investment Value: Value to a specific investor based on that investor's requirements, tax rate, financing, etc.

Insurable Value: Value of those portions of the property that are physically destructible -- utilized for insurance coverage.




Assessed Value: Value established by the tax assessor. Used to determine and levy local real estate taxes.

 Liquidation Value: Likely price that would result from a forced sale such as a foreclosure or tax sale.  Utilized when sale must occur with limited exposure to the market or under restrictive conditions.



Reproduction Value: Value of a substiute property identical to the subject property including use of same era of materials, design features and construction methods.

Replacement Value: Value of a substitute property having substantially the same utility as the subject property, but using modern materials and design / construction practices.

Price, Cost & Value....Oh My!

Too many times the terms price, cost and value are used interchangeably.  In real estate appraisal each has a specific definition that differentiates it from the others.

 

Price: Refers to either the asking or selling price that was actually requested or offered for a property, presently or in the near past. Price represent's a person's individual assessment of value NOT the broader, more objective, non-personal assessment that appraiser's strive for.

 

 

Cost: The actual dollar amount paid for a property in the past or dollar amount needed to build or improve a property at a specific time.  Cost may or may notbe equal to the market value of the improvement depending onmarket conditions, which may inflate or depress rents, vacancies, interest rates, etc.

 

 

 

Value: Traditionally defined as the power of a good to command other goods or services when exchanged in the market place.  There are several types of value that will be discussed in more detail in an upcoming blog entry.

Approaches to Appraisal Value -- An Overview

There are three generally accepted approaches for deriving a property value in the appraisal process.  They are the cost approach, sales comparison approach and the income approach.  Each is described below:

The Cost Approach:  The theory is that the value of a property can be estimated by summing the land value and the depreciated value of any improvements. The value of the improvements is either measured as reproduction cost minus depreciation or replacement cost minus depreciation. Reproduction refers to reproducing an exact replica. 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 almost always use replacement cost and then deduct a factor for any functional dis-utility associated with the age of the subject property. The cost approach is often the only reliable approach when dealing with special use properties such as public assembly arenas, marinas, oil refineries and the like.

 

The Sales Comparison Approach:  The sales comparison approach in a real estate appraisal is based primarily on the principle of substitution. This approach assumes a prudent individual will pay no more for a property than it would cost to purchase a comparable substitute property. The approach recognizes that a typical buyer will compare asking prices and seek to purchase the property that meets his or her wants and needs for the lowest cost. In developing the sales comparison approach, the appraiser attempts to interpret and measure the actions of parties involved in the marketplace, including buyers, sellers, and investors.

 

Data and valuation information are collected on recent sales of properties similar to the subject being valued, called comparables. Only SOLD properties may be used in an appraisal and determination of a property's value. Sources of comparable data include real estate publications, public records, buyers, sellers, real estate brokers and/or agents, appraisers, and so on. Important details of each comparable sale are described in the appraisal report. Since comparable sales aren't identical to the subject property, adjustments may be made for date of sale, location, style, amenities, square footage, site size, etc. The main idea is to simulate the price that would have been paid if each comparable sale were identical to the subject property. If the comparable is superior to the subject in a factor or aspect, then a downward adjustment is needed for that factor. Likewise, if the comparable is inferior to the subject in an aspect, then an upward adjustment for that aspect is needed. From the analysis of the group of adjusted sales prices of the comparable sales, the appraiser selects an indicator of value that is representative of the subject property.

 

 

The Income Approach:  The income approach can utilize the capitalization method or the discounted cash flow method.

 

The income capitalization approach is often 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.

 

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 a Net Operating Income (NOI). Usually, an NOI has been stabilized so as not to place too much weight on a very recent event. An example of this is an unleased building which, technically, has no NOI. A stabilized NOI would assume that the building is leased at a normal rate, and to usual occupancy levels. 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 or major shopping centres. This technique applies market-supported yields (or discount rates) to projected 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.

What is Real Estate Appraisal?

Real Estate Appraisal is simply the process of valuing real property. The value usually sought is the property's market value.  But how are appraisals needed and how are they utilized? 

 

 

Why are Appraisals Needed?:  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. 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. Thus, the appraiser usually provides a written report on this value to his or her client.

 

 

 

How are Appraisals Utilized?   Appraisal reports have many uses.  They can be used as the basis for mortgage loans, for settling estates and divorces, for tax matters, for determining appropriate levels of insurance, and to determine the prce at which a property should be bought / sold.  Appraisals are commissioned by property owners, investors, insurance companies and other participants in the real estate industry.