Knowing what an appraisal is

An appraisal is an estimate or opinion of value usually undertaken by a trained individual licensed or certified to do this work based on research in the real estate market. The term appraisal refers to the work itself as well as the written product of that work. This definition often appears on state licensing exams and may sometimes be stated simply as an opinion of value.

The words “estimate” and “opinion” are important in this definition. Notice, for example, that I don’t define an appraisal as a calculation of value. Although appraisers use a variety of mathematical techniques in their work, the act of arriving at the value of a particular piece of property can never be that precise. So appraisers never say that they calculate value.

An appraiser is a researcher, a private detective. To come up with an estimate, the appraiser investigates the following:

• Economic factors: Employment and interest rates.
• Environmental factors: The presence of pollutants in the area or on the land.
• Physical factors: The real estate’s location, size, and condition.
• Social factors: Demand for a particular type of housing (such as demand by an aging population for a certain type of house).

The property being appraised is called the subject property. Although the definition of the term subject property isn’t critical for exam purposes, you need to understand the reference whenever you’re asked a question that refers to the property being appraised.

Another important item to remember is that the client hires the appraiser to provide an objective opinion of the value of the subject property. Most appraisers work independently on a fee-for-service basis; therefore, they have no interest in what the property value is. Furthermore, the code of ethics and standards that licensed and certified appraisers must follow requires them to reveal any interest in the property they’re appraising to the client. Say you find a property you want to buy, and you want to find out whether the asking price is fair. You look in the yellow pages, and hire Mary Appraiser, but it turns out that Mary’s mother owns the property. Mary must tell you about her interest in the property or be in violation of the code of ethics and standards.

Seeking an appraisal: Why you need one

Hiring an appraiser for real estate transactions often is a big decision, and many reasons merit such a step. Anytime value is an issue, you may want to have an appraisal done. The following list includes reasons why people most often have appraisals done.

I cover the details of some of the following subjects in other chapters. For exam purposes, however, what you need to remember from the following information is a general list of why appraisals may be done:

• Buying: Buyers of real estate can hire an appraiser to determine the fairness of the asking price of the property.
• Eminent domain: When the government seizes privately owned real estate for public use through eminent domain, it must pay for the property. The government determines the amount of payment with the help of an appraisal (see Chapter 8).
• Estate valuation: When someone dies, federal or state taxes may have to be paid on the value of the estate. If the estate includes real estate, the property has to be appraised to establish the estate’s value as of the date of death.
• Exchanges of ownership: When owners exchange real estate, rather than selling it for money, the appraiser establishes the values of the properties to determine the fairness of the exchange (find information on property exchanges in Chapter 17).
• Mortgage approval: Mortgage lenders, that is, banks, savings and loan associations, and other lenders order the vast majority of appraisals. When buying or refinancing a property, the borrower puts the property up as collateral. If the property owner defaults on the loan, the lender takes the property and sells it. The lender wants to be sure that if the owner defaults, the property value covers the loan. (For more information on mortgages, see Chapter 15.)
• Property taxes: Real estate taxes are based on assessed values, which, in turn, are based on market values. Appraisals are sometimes done for clients who want to argue with municipal (city, town, and village) tax assessors for lower assessed values to obtain a reduction in taxes (I talk about taxes in Chapter 16).
• Selling: People who want to sell their real estate can seek an appraisal to determine a fair and competitive asking price for their property. Most often a seller asks a real estate agent for his opinion of value when preparing to sell a house.
• Taxes other than property taxes: Taxes often are due when someone gives a piece of real estate to someone as a gift. Alternatively, there may be a tax benefit in the form of a deduction if someone gives real estate to a charitable organization. In both cases, an appraiser comes in to determine the property’s value.
• Various court proceedings: Bankruptcy, divorce, and the dissolving of a partnership or corporation may all involve real estate holdings. Appraisals usually establish the value of the property in question.

You can’t move it

The most important characteristic of real estate and the reason location is such an important factor in its valuation is the fact that real estate is immobile. Exam questions in this area usually focus on the issue of immobility being the reason location is such an important value characteristic.

Unlike personal property, you can’t move real estate. Think about this statement: It’s what makes real estate so unique and the location issue so important. Say you own a piece of real estate in a low crime neighborhood. And over time that neighborhood begins to change and becomes somewhat unsafe. You just move the real estate, right? You can sell the real estate and move, but you can’t move the real estate itself. What’s more, because you can’t move the real estate and the environment around it has changed, the value of the real estate probably has changed, too.

Not so with your brand new car. If you think it’s unsafe to park on a street, you just park on a different block or in a parking garage.

You’re not on Gilligan’s Island

The fact that real estate can’t be moved makes it particularly vulnerable to the effects of the surrounding area, which can be positive, such as a piece of residential real estate located in what is perceived to be a good school district. The influence on value can be negative if, for example, the real estate is located near a sewage treatment plant. My point is this: You’re not on an island. Unless of course you are, in which case you have a 360-degree waterfront view — so who’s better off than you?

Real estate is immobile and highly affected by its surroundings; therefore, I provide the following list of some (but not all) of the environmental factors outside of the real estate itself that may affect value. And this is what is generally meant by real estate location:

• Access to employment: Are there employment centers and therefore jobs available within a reasonable distance?
• Amenities and services: Can you find shopping centers, libraries, restaurants, and so on?
• Hazards and nuisances: Is the real estate too close to gas stations, waste processing plants, or other unsightly or hazardous land uses?
• Nearness to transportation: Are you near highways or public transportation?
• Neighborhood compatibility: The surrounding land uses are similar to your real estate.
• Safety: Make sure the crime levels are as low as possible.
• Schools: You may want to check with neighbors about the perceived quality of the schools. (See Chapter 5 for information about possible fair housing issues when discussing the quality of schools with a client or customer.)
• Traffic: Are the surrounding roadways residential or commercial streets?

Going into detail on each of these points isn’t important, but if you want to pass the exam, remember that many of these factors are relative to the particular piece of property in question. For example, most people don’t want their homes located on a heavily traveled street, but if you own a business property, then that is exactly where you want to be located.

You can’t make any more of it

The amount of land available is limited. That may seem obvious, but think about it in the context of a car, a chair, or anything else that can be manufactured. You can make more of those products, but you can’t make any more land. Only a limited amount of land is available anywhere. That of course doesn’t make all land valuable, but it does say something about the value of property wherever people want to be.

If you look at the list in the previous section, I think you’ll agree that most people want to live in safe neighborhoods with good schools and easy access to jobs and shopping. However, only so many of those properties are available at any point in time. Given that many people want to live in those neighborhoods, a competition ensues for those pieces of real estate and that competition raises prices.

Going to market … value, that is

Market value is the value that appraisers deal with most often. It’s the value we’re most often concerned with in the typical real estate transaction. Typical is a key word here. A typical buyer and a typical seller will establish market value with the price the seller is willing to sell for and the buyer is willing to pay. Keep in mind that both seller and buyer typically know as much about the property as they can, have access to needed expertise like attorneys or home inspectors, act in response to typical motives like wanting a house to live in, and have sufficient time to look at a number of properties that have been on the open market. Anything that changes these typical motivations may change the sale price of the real estate but not its value.

For example, the old family homestead where your grandfather grew up is on the market and you just have to have it for sentimental reasons. Its market value is $150,000. But because you’re so anxious to get it you offer and pay $200,000 for it. Its market value is still $150,000 even though the price paid is $200,000. Why? Because your motivation was personal, not typical. Typical buyers would have paid no more than $150,000, because they’d see it only as a normal place to live.

A sale meeting the market value criteria also presumes what is known as an arm’s length transaction. An arm’s length transaction implies that no relationship exists between the parties and that the buyer and seller each act in his or her own best interest. So buying your brother’s house wouldn’t be considered an arm’s length transaction. Most exams ask for this definition, in relation to market value.

Value in use

Value in use is the value a property has to a specific person who may use it for a specific purpose that’s generally unavailable to the typical buyer.

Suppose a doctor obtains special permission from the city to use two rooms in a house as a medical office. The typical buyer looks at such a house and puts a value on those rooms for family or personal use, such as a family room or den; however, another doctor looking at that property may be willing to pay a higher price because of his ability to use those rooms as a medical office. The typical buyer pays market value, while the doctor pays a higher price based on value in use.

Investment value

Investment value is the value to a specific investor with a specific plan for the property. Unlike value in use, which generally presupposes a use already in place, investment value assumes a use that may be proposed. Investor A may be willing to pay $3 million for a warehouse to be used as a warehouse. Investor B wants to convert the warehouse to a multiscreen movie theater. Investor B may want to pay only $2 million for the warehouse because of the additional expenses for the movie theater conversion project. Investor B probably would look for another piece of property that meets his investment criteria.

Assessed value

Assessed value is the value placed on a property for tax purposes. It is associated with the term ad valorem, which means according to the value. I cover assessed value in Chapter 16.

Anticipation

All property value is created by the anticipation of the future benefits the property will provide. You buy your house today (and set the price today) so you can enjoy a bigger house for years to come.

Balance

You find a balance between land value and building value in any given area. Overall property values and builders’ profits on new homes are maximized when that balance is maintained. For example, in most cases you never want to build a house that costs $100,000 on a piece of vacant land that costs $500,000 (unless of course there was gold on the property; then who cares how much the house costs). No universal magic number exists for the proper balance between land and building value. But in general the balance needs to be similar to that which exists in the surrounding neighborhood.

Change

Change is closely related to anticipation. The idea of change is that nothing remains the same. Physical, governmental, economic, and social changes all affect property value. Physical factors can include environmental changes such as weather, pollution, and earthquakes. Governmental factors may include changes in development regulations like zoning or the construction of new roads. Economic issues may be a change in interest rates or employment levels in an area. Social factors are issues like the aging of the baby boomers. Any or all of these and others can have an impact on the values of properties.

Competition

Competition describes the fact that in real estate, the supply side (developers and builders) tries to meet the demand side (buyers and renters) until their demand is satisfied. A developer may see a need for a new office building in a particular location. If that building is a success, other builders are likely to follow with more office buildings until the last office building a builder erects remains partially vacant because the suppliers have created a surplus of office space.

Conformity

Value is created and sustained when real estate characteristics are similar. If you live in a neighborhood of single-family houses, you don’t want an office building to be built across the street from your house. The price of your house probably will be negatively affected by that incompatible land use.

Contribution

In real estate terms, a building or a faucet is worth the value the market places on it, not its cost. You can spend a million dollars building a house, but if it’s in the wrong location or has an extremely unusual design, it may not be worth a million dollars. On the other hand, a $1,000 paint job may increase the ultimate selling price of the house by $5,000.

Externalities

Real estate, because it stays in a fixed location, is affected by everything that happens around it. The gas station on the corner, the quality of the schools, the factory that closes in town, mortgage interest rates, and so on all have an impact on the property value.

Highest and best use

The principle of highest and best use states that every property has a single use that results in the highest value for that property. The use must meet four criteria. It must be

• Physically possible: You can’t build an airport on a two-acre piece of property. In fact, you can’t build a regional shopping center either. But you can build a house or apartment building.
• Legally permitted: You may physically be able to build any of the structures I listed previously, but if the zoning or deed restriction say that all you can build is a store or an office building, then your list of possibilities has just been narrowed considerably.
• Economically feasible: Depending on the market conditions at the time, you may find that one or the other of the physically possible and legally permitted uses isn’t economically feasible, which means that you won’t make money on that use.
• Most (maximally) productive: If you get to this point in the analysis and you still have at least two uses that meet the first three criteria then you need to determine which use will result in the most value. That becomes your highest and best use. If you get to the economic feasibility criteria and only one use emerges from that analysis, then that’s your highest and best use.

Increasing and decreasing returns

Increasing and decreasing (sometimes called diminishing) returns relate to adding improvements to a piece of real estate. Increasing returns come in when an improvement adds more value to the real estate than its cost. A dollar spent gives you more than a dollar back. Decreasing returns occur when an improvement gives back less value than its cost. The principle of increasing and decreasing returns is based on the principle of contribution, which I discuss in the earlier “Contribution” section.

An example of this principle might be adding bathrooms in a new house (or adding them to an old house). My numbers here are for illustrative purposes only. Each bathroom may cost you $6,000, but the first one may net you back $10,000 in terms of value. The second one may net $8,000, and the third one only a break-even $6,000, the fourth one $3,000, and the fifth one nothing. The returns on each bathroom go from increasing the value to creating no additional value. It’s obvious that the buyers are putting less and less value on what are essentially unneeded bathrooms.

Opportunity cost

For every investment opportunity you choose, you lose other investment opportunities. So when Auntie dies and leaves you $100,000, you can invest it in real estate. In doing so, you miss the opportunity to invest the money in certificates of deposit at the bank. And if you can get a 4 percent return on your money at the bank, you give up that return by investing in real estate. So you better make at least 4 percent and then some in your real estate investment.

Plottage

The plottage principle states that the whole is sometimes greater than the sum of its parts, particularly with respect to real estate. You can put together four individual 5-acre parcels of land, each worth $50,000, to create a single 20-acre piece of property. This larger piece may now enable you to do something with it that was impossible with the smaller pieces, such as building a regional-size shopping mall. It turns out the value of the whole property, or the plottage value, is now $300,000 rather than four times $50,000, or $200,000. The act of putting the individual properties together is called assemblage.

Regression and progression

You’ve heard the advice that you should always buy the smallest house in the neighborhood and not the biggest one. If you ever wondered why, it’s because the principle of progression says that the higher values of larger homes tend to have a positive effect on the lesser value of the smaller home. Conversely, lower-priced homes have a negative effect on the value of the higher-priced home.

Substitution

This economic principle says that a buyer will try to pay as little as possible for the property that meets the buyer’s needs. Given three houses, each of which satisfies the needs of the buyer, that buyer will buy the least expensive house.

Supply and demand

Because only so much land can be found in any particular location, and therefore only so much of anything — houses, stores, office buildings — can be built, the balance between supply and demand affects value. If demand goes up and supply goes down or remains the same, value increases. If demand goes down and supply increases or stays the same, value decreases. Sometimes on an exam the tester mentions only one of these factors, for example what happens to prices or values when housing demand goes up? The implication is that the other factor, in this case supply, stays the same. So don’t get confused.

Surplus productivity

After the builder puts together the land, labor, materials, and coordination necessary to build a building and then sells it, the difference between the costs and the selling price is surplus productivity. Economists use this term to signify profit.

Understanding the basics

The idea behind the sales comparison approach is to compare previous sales of real estate to the subject property being appraised to arrive at an estimate of the real estate’s value.

You ask Joan the appraiser to appraise a three-bedroom, two-bath, 2,500-square-foot house in a typical suburban subdivision. Through her research into the sales in the area, Joan finds three sales of almost identical houses in the last four months. These previously sold houses are called comparables or comps. Each of the houses sold for $250,000. Joan, by the way, is a very lucky appraiser, because even similar houses don’t often sell for the same price. Joan estimates that the value of the house she is appraising is $250,000 based on the fact that three similar homes recently sold for that price. And that is the sales comparison approach at its simplest.

An appraiser normally investigates as many as ten or more comparables, finally selecting a minimum of three to five to use in the sales comparison approach. After making all the appropriate adjustments to each of the comparables (see the next section), the appraiser examines the comparables and arrives at a value estimate for the property. It seldom occurs that the three adjusted sale prices are exactly the same. In this case, the problem is easy because the prices are all the same. Where the prices are different, the appraiser never averages the three prices but rather analyzes the comparables and the various adjustments made, and through experience and trained judgment arrives at the value estimate.

Adjusting the sales price

The situations that appraisers most often have to deal with in applying the sales comparison approach are comparables that aren’t identical to the subject property. Appraisers go through an adjustment process to compensate for the differences in the properties.

The adjustment process is really quite simple and pretty intuitive. And the people who write the state tests expect you to understand it and be able to apply it.

The subject property is a three-bedroom, two-bath home. Joan the appraiser doesn’t currently know the value of this house. A very similar house sold two months ago for $325,000. The comparable house, called Comparable A, is the same in all respects as the subject property except that it has four bedrooms. Comparable A is superior to the subject property. Joan’s research indicates that the value of the fourth bedroom is $25,000. That means that the buyer of Comparable A paid $25,000 more for that house than he or she would have for a three-bedroom house.

Joan, when preparing her appraisal report, goes through the process of subtracting that $25,000 bedroom value from the $325,000 sales price of Comparable A. The resulting price of $300,000 is the adjusted sales price.

$325,000 (sale price of Comparable A) – $25,000 (value of fourth bedroom) = $300,000 (adjusted sales price)

Using the principle of substitution, the adjusted sales price for Comparable A, or $300,000, is the estimated value of the three-bedroom house.

Now look at an opposite kind of adjustment. Joan is still appraising the three-bedroom, two-bath house. She finds another comparable, which she calls Comparable B. This comparable also is the same as the subject property except that it has only one bathroom. It is inferior to the subject and sold for $290,000. Her research indicates that the value of that second bathroom is $10,000. What does she have to do to make the comparable like the subject? She has to add a bathroom, or more specifically, the value of that second bathroom.

$290,000 (sale price of Comparable B) + $10,000 (value of second bathroom) = $300,000 (adjusted sales price)

The adjusted sales price for Comparable B, or $300,000, is the estimated value of the two-bathroom house.

The adjustment process is a matter of adding or subtracting the value of the differences between the subject property and the comparable property to or from the comparable. Take a look at that again, because this part tends to confuse people. You make the adjustments to the comparable to make the comparable property like the subject property. So keep your hands off the subject. The adjusted comparables indicate to the appraiser the estimated value of the subject property.

It isn’t old, it’s mature: Making age adjustments

When I talk about age, I’m not talking about the age of the appraiser; I mean the age of a structure. The market (that is buyers and sellers) takes the age of a structure into account when deciding on what to pay.

Here’s a little brain teaser: The subject property is 5 years old, and the comparable is 15 years old and sold for $190,000; otherwise, the houses are similar. The value of that ten-year difference in age is $5,000. Should you add or subtract that $5,000 from the sales price of the comparable? That’s right, you need to add the $5,000 because the 15-year-old house is considered worse than or inferior to the 5-year-old house. For now, I made up the $5,000 figure but in another part of this chapter in the “Finding adjustment values” section, I discuss how you can find the value of an age or any other type of adjustment.

For some reason, when age numbers are introduced into the problem of making adjustments, the direction (plus or minus) of the adjustment becomes a little muddled. But if you apply the superior/inferior test, it becomes clear immediately. Older is considered worse; therefore, you add the adjustment value to the comparable sale. Newer is considered better; therefore, you subtract the adjustment value from the comparable sale.

Having time to adjust for time

The sales comparison approach is based on previous sales of similar houses (comparables) to indicate the current value of the property being appraised. The word “previous” can cause some difficulty, because real estate values tend to change over time. As recent history has shown real estate values can go up or down.

Take a look at an example of what is usually called a time or market adjustment. Once again, Joan the appraiser is appraising a house. She finds a comparable house that is almost identical in all respects to the subject property. The comparable house sold for $300,000 five months ago. Her research indicates that the real estate market has been quite strong in the area and property values have gone up approximately 1 percent per month during the past five months. To properly account for this rise in property values, Joan needs to ask the question, “What would the comparable have sold for if instead of selling five months ago, it sold today?” It would sell for 5 percent more. The adjustment calculation becomes

• 1 percent per month × 5 months = 5 percent
• $300,000 (sale price of comparable) × 5 percent (increase in value for five months) = $15,000 (value of time adjustment)
• $300,000 + $15,000 = $315,000 (adjusted sales price)

The adjusted sales price for the comparable, $315,000, is the indicated value of the subject property.

You calculate a downward trend in property values over time the same way, only the value of the time adjustment is subtracted from the sales price of the comparable to give you the value of the subject property.

And for you mathematical whizzes who are wondering about compounding the 1 percent per month, the common practice is to simply add the monthly increases in real estate value to get a total percentage increase for the period of time you’re dealing with.

Figuring adjustment values

By now you’re probably wondering where all these adjustment values come from. In fact many of my appraisal students think there’s some kind of standardized set of numbers as to how much a bathroom or bedroom is worth. Although no such set of numbers exists, a method for getting those numbers does.

The main way appraisers find the value of an adjustment is by extensively analyzing the market and using a technique called paired sales analysis to find these adjustment values. Paired sales analysis is based on the idea that if two houses are similar in all respects except one, and the sales price of each home is different, the dollar amount of difference between the two houses is the likely to be value of the unique attribute or feature of one of the houses. Look at these two houses for an example. House A has four bedrooms. It sold for $400,000. House B, which sold for $360,000, has three bedrooms. In all other respects, House B is the same as House A. The only physical difference between the two houses is the fourth bedroom, along with a monetary difference of $40,000 between the two sale prices. The fourth bedroom, in this case, is worth $40,000

The appraiser can now take that $40,000 figure and use it wherever appropriate to make adjustments to comparables when applying the sales comparison approach to estimating value.

A journey begins with the first step … or a formula

The formula for the cost approach is as follows:

Replacement or reproduction cost – depreciation + land value = value

A breakdown of the steps of this method follows:

1. Estimate the replacement or reproduction cost of the improvement (structure).

   Turn to the section “Estimating replacement and reproduction costs” for instruction.

2. Estimate all the depreciation of the improvement (accrued depreciation).

   See the section “Estimating depreciation” for more info.

3. Subtract accrued depreciation from the reproduction/replacement cost.

   Accrued depreciation is the total of all the estimated depreciation.

4. Estimate the land value separately.

   Flip to the section “Dirt costs money, too: Estimating land value” to discover the way.

5. Add the depreciated cost of the structure to the land value.

   The result is the estimate of value.

I devote the rest of this section to a discussion of each of these concepts.

The cost approach has a lot of terminology that may be unfamiliar. Remember, most salesperson’s tests ask a lot of definition questions.

Estimating replacement and reproduction costs

Reproduction cost is the cost to construct an exact duplicate of the subject structure at today’s costs. Replacement cost is the cost to construct a structure with the same usefulness (utility) as a comparable structure using today’s materials and standards.

For example, you may use the cost approach to appraise a house with plaster walls. A reproduction cost estimate requires estimating the cost to construct plaster walls. A replacement cost estimate, however, estimates the cost to put up sheet rock walls according to the current standard.

Replacement cost is most often used in the cost approach. Reproduction cost would be used for say historically or architecturally significant structures.

Two types of costs are included in every construction cost estimate: direct costs and indirect costs. Direct costs, also called hard costs, are those expenses directly associated with the actual construction of a building, including labor and building materials. Indirect or soft costs are expenses not directly related to the physical construction process, including permit fees, architectural costs, and builder’s profit. Direct and indirect costs are part of the estimate of the costs.

You should know the four methods for estimating reproduction or replacement cost. For exam purposes, your ability to distinguish among the four methods by their characteristics is sufficient. Generally, no calculations are required. The four methods include

• Square footage method: Involves calculating the cost of construction by multiplying the square footage of the structure by the construction cost for that particular type of building. For example, you’d multiply a $100 per square foot cost to build the kind of house you’re appraising by the 2,000 square foot total area of the house to arrive at a cost estimate of $200,000 to replace the structure. The square footage method is the one more commonly used by appraisers to estimate replacement or reproduction cost.
• Unit-in-place method: Provides the cost to construct a building by estimating the installation costs, including materials, of the individual components of the structure. So if you know you need 1,000 square feet of sheet rock to cover the walls, you need to find out the cost of buying, installing, and finishing the sheet rock on a per-square-foot basis and then multiply by 1,000 square feet. Another approach to this method is to estimate the four main steps (units) to building a house. For instance, cost of foundation, cost of roof and framing, cost of mechanicals, and cost of walls and finish work. Each step is estimated separately and then all are added together.
• Quantity survey method: More detailed than the previous method, it requires you to break down all the components of a building and estimate the cost of the material and installation separately. So in the sheet rock example, you estimate so many dollars each to buy the sheet rock, screws, and tape, and to pay for the installation.
• Index method: Requires you to know the original construction cost (without land) of the subject building, the construction cost index number at the time, and the current index number. You then multiply that original cost by a number that takes into account the increase in construction costs since the building was built. National companies that do this kind of research publish these numbers. If a building cost $100,000 to build originally, the construction cost index at the time of construction was 125, and the current index in that area for this type of structure is 175, the calculation is 175 ÷ 125 = 1.40. $100,000 (original construction cost) × 1.40 = $140,000 to construct the same building today.

Estimating depreciation

Now you’ve arrived at the second step in applying the cost approach to estimating the value of a piece of property. Depreciation is the loss in value to any structure due to a variety of factors, such as wear and tear, age, and poor location, each of which I discuss in this section. I generally view depreciation as the difference in value between the perfect new structure cost that you estimate and the actual value of the structure that’s being appraised.

The term accrued depreciation means the total depreciation of a building from all causes. You should also note that accrued depreciation isn’t the kind of depreciation that concerns accountants when they depreciate a building or a piece of equipment for tax purposes. Licensing exams generally ask two types of questions about depreciation: A question asking for the definition of a particular type of depreciation and a question giving you an item of depreciation and asking you what type of depreciation that item represents. Occasionally you may get a question that asks you to calculate depreciation using a very simple technique known as the straight-line method. I review that technique in the section “Don’t be a square: The straight-line method of calculating depreciation,” later in this chapter.

Dirt costs money, too: Estimating land value

The final step in the cost approach is for the appraiser to develop an estimate of the land value and add it to the depreciated value of the reproduction or replacement cost. Appraisers use a variety of methods to calculate land value. The methods vary with the type of land being appraised and the information available.

The most commonly used method for estimating the value of a single piece of property on which you’d build a house is the sales comparison approach. (For more information, see “Finding Value by Analyzing Comparable Sales,” earlier in this chapter.) Features like the land’s location, topography, view, and size and shape are compared to arrive at an estimate of value. The intricacies of the various methods of site appraisal are beyond the scope of sales and brokers license exams, so you need not worry about that.

Grossing out the rent

The Gross Rent Multiplier (GRM) and Gross Income Multiplier (GIM) techniques for estimating value are based on the idea that a property value can be calculated as a multiple of the gross rent. These formulas state this succinctly:

• Gross monthly rent × GRM (factor) = value estimate
• Gross annual income × GIM (factor) = value estimate

The gross rent is the monthly income of the building with no deductions for expenses. Because single family and smaller residential apartment buildings of fewer than five units depend primarily on rental income, the GRM technique is used for these types of buildings. Larger apartment buildings and nonresidential commercial properties may have income in addition to rentals. In this case, the income used is gross annual income rather than monthly rent and the factor is known as the Gross Income Multiplier (GIM). Other than that, all the formulas are the same.

You’re now correctly asking, “So where do I get the GRM or GIM factor?” As with all the data appraisers use, they calculate it based on the market. After getting all the information needed on the subject property, the appraiser researches the market for that type of property, which is usually the local market, to obtain a number of comparable sales. Comparable sales are recent sales of similar buildings. After locating a number of similar buildings, the appraiser needs to find the sales price and the gross income of each building. By dividing the sales price of the building by the gross rent, the appraiser obtains a GRM or GIM for each of the comparables. If the buildings are similar, which they should be if they’re comparable, the gross rent multipliers also will be similar numbers. Remember: If you’re dealing with a GRM, you’re using monthly rent figures. If you’re working with a GIM, the income figures are annual. Here I give you examples of each.

You may want to note that when you leave the classroom and are working on your first million dollars in real estate, buyers and sellers may use these terms interchangeably so you may find yourself talking about a GRM using annual rent numbers. You always need to be clear in your conversations with buyers and sellers in understanding what they and you are referring to. The distinctions I make in the previous section however should get you through the exam.

Say you’re appraising a three-unit residential rental property. The gross monthly rent of this property is $1,000 per apartment or $3,000 per month for the whole building. You research similar buildings and find three comparable properties that are in the same location, approximately the same size, and that generate approximately the same gross monthly rent. The data is shown here:

You now apply the formula for finding the GRM to this data.

Sales price ÷ gross monthly rent = GRM

Applying the formula to the example data, you find that the GRM for each of the comparables would be 100, which means that the comparable buildings each sold for a price that was 100 times its gross monthly rent. The final step is to apply the value formula to the subject property:

• Gross monthly rent × GRM = value estimate
• $3,000 × 100 = $300,000

Now say you want to estimate the value of a small commercial building whose monthly income is $7,000. You find the following three comparables.

Using the formula — Sales price ÷ Gross annual income — you’d find that each building sold for ten times its annual income.

Then applying the formula — Gross annual income × GIM = Value — $84,000 × 10 = $840,000.

Note that in the problem I give you a monthly income figure of $7,000. You need to multiply this times 12 in order to arrive at the annual income of $84,000.

The GRM method is particularly useful for small-income-producing properties, such as one- to-four-unit residential properties. The GIM technique is more useful for larger residential properties as well as commercial and mixed-use properties. For more math related to the GRM, see Chapter 18.

Capitalizing the income

Another method for appraising real estate based on its income is known as the income capitalization approach. Like the GRM and GIM, this method converts the income of a property into an estimate of its value. Appraisers generally use this method for commercial buildings such as shopping centers, office buildings, and large apartment buildings. The basic formula for this approach, commonly referred to as IRV, is

Net operating income (I) ÷ capitalization rate (R) = value (V)

You can break this formula down into these three steps:

1. Estimating the net operating income.
2. Determining the capitalization rate.
3. Applying the IRV formula to arrive at a value estimate.

Keep in mind that I cover more math related to capitalization in Chapter 18.

1. What approach to value would be most suitable to appraise a shopping center?

(A) Income approach

(B) Cost approach

(C) Sales comparison approach

(D) Reconstructed value approach

Correct answer: (A). Real estate that is purchased for investment, such as a shopping center, generally is appraised using the income approach.

2. In the direct sales comparison approach, what type of adjustment should you make when the comparable is better than the subject?

(A) Positive to subject

(B) Negative to subject

(C) Positive to comparable

(D) Negative to comparable

Correct answer: (D). Two things to remember here: First, you never adjust the subject, only the comparable. Second, when the comparable is better than the subject, the adjustment is negative.

3. A buyer who buys the least expensive house available to satisfy his needs is behaving according to what economic principle?

(A) Supply and demand

(B) Anticipation

(C) Progression

(D) Substitution

Correct answer: (D). Note that this is a short case study question. The test also asks straight definition questions about these economic principles.

4. Reproductions cost is

(A) used in the income approach to value.

(B) the cost to construct a building using modern materials.

(C) the cost to construct an exact duplicate of the building.

(D) the same as market value.

Correct answer: (C). Reproduction cost is the exact replacement of the structure. Replacement cost is a structure having the same utility (usefulness) but using modern materials.

5. The rent on a house is $500 per month. The gross rent multiplier is 180. What is the estimated value of the house?

(A) $270,000

(B) $1,080,000

(C) $36,000

(D) $90,000

Correct answer: (D). Gross monthly rent × gross rent multiplier = value.

$500 × 180 = $90,000

Don’t multiply the rent by 12. This formula is based on monthly rent.

6. If a building’s net operating income is $1,000 a month and an appraiser uses a rate of return of 10 percent, what is the estimated value of the building using the income capitalization approach?

(A) $100,000

(B) $1,000,000

(C) $120,000

(D) $1,200,000

Correct answer: (C). I ÷ R = V

$12,000 ÷ 10 percent (expressed as 0.10) = $120,000

Remember that with the income capitalization approach, you always use the annual income. So the first step is multiplying the monthly income by 12 months. Test writers also sometimes use the term property to mean any type of real estate. They also use the term rate of return to mean a capitalization rate. Don’t be thrown by these references.

7. The reproduction cost of a house is estimated at $120,000. Its economic life is 50 years. Its effective age is 20 years. What is the depreciated value of the house?

(A) $72,000

(B) $48,000

(C) $60,000

(D) $96,000

Correct answer: (A). Read the question carefully (that goes for all questions) and make sure you do every step.

• 1 ÷ economic life = rate of depreciation per year
• = 2 percent per year
• Rate of depreciation per year × effective age = total rate of depreciation
• 2 percent × 20 = 40 percent
• Reproduction or replacement cost × total rate of depreciation = total amount of depreciation
• $120,000 × 40 percent (expressed as 0.40) = $48,000
• Reproduction or replacement cost – total amount of depreciation = depreciated value
• $120,000 – $48,000 = $72,000

8. A subject property has four bedrooms. A comparable has three bedrooms and sold for $160,000. In all other respects the properties are alike. The value of the fourth bedroom is estimated to be $20,000. What is the indicated value of the subject?

(A) $180,000

(B) $160,000

(C) $80,000

(D) $140,000

Correct answer: (A). If the comparable is worse than the subject, you add the adjustment amount to the comparable. The comparable has one less bedroom than the subject. So you add the $20,000 value of the bedroom to the comparable.

9. A comparable sold for $110,000 five months ago. You estimate that real estate values have been rising at 1 percent per month during that period of time. How much is an identical house worth today?

(A) $5,500

(B) $116,600

(C) $104,500

(D) $115,500

Correct answer: (D). 5 months × 1 percent per month = 5 percent

• $110,000 × 5 percent (expressed as 0.05) = $5,500
• $110,000 + $5,500 = $115,500

10. What appraisal approach would an appraiser most likely use to appraise a sports arena?

(A) Cost approach

(B) Income capitalization approach

(C) Gross rent multiplier approach

(D) Sales comparison approach

Correct answer: (A). Sports arenas are fairly unique, and you can seldom find comparable sales. Stadiums also are built as service-type buildings rather than investment properties. The cost approach most often is used for unique real estate.