Fundamental concepts

of Real Estate Appraisal

Presented By: Hari Shanker

Manoj Kumar
Naveen Kumar
 Recovery in the real estate
market normally precedes a
recovery in the national
• economy
• As home construction picks up,
employment, and spending increase. This
in turn generates even more activity, and
the general business cycle heads for
recovery


• However, if spending and demand rise

beyond the equilibrium point, inflation will
recur. If this happens, the RBI my tighten
up the money supply, and the mortgage
market will start to loose funds, causing
real estate industry to decline
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• The real estate market (Cycle) in the
short run tends to travel somewhat
opposite to the general business
cycle.
• When the general economy is at the
top of a boom, real estate activity
is usually already declining because
of a lack of credit. When the
general economy slows down, real
estate activity may increase as
funds flow back into the mortgage
 Important economic features
of Real Estate:
• Few participants
•
• Buyers and sellers are not knowledgeable; the
exchange is legalistic, complex, and expensive
•
• Each parcel of real estate is unique and separate
from all others; no two parcels are exactly alike
•
• The location is fixed; a real estate market is local,
not regional or national
•
• Real estate is purchased infrequently; a home
represents the single investment made by the
average family

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• Govt. plays a dominant role in encouraging or
discouraging real estate development through
the use of fiscal and monetary tools.
• Prices are influenced by the interaction of supply
and demand, but this interaction is not smooth;
the lack of knowledge by either the buyer or
seller can distort the prices paid


• Supply of land is fixed

•
• In short run, land use is also fixed


• A fixed supply means that real estate prices

fluctuate with demand
 Real Estate Investment
Principles
 Five major economic characteristics:
• Return: recovery of benefits
• Management: the supervision
needed to oversee the investment
• Taxability
• Liquidity: the ease and speed of
converting the investment into
cash
• Risk: the danger of loss of the
investment
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 The categories of Risk are:
•
• Financial risk
•
• Interest rate risk
•
• Purchasing power risk
•
• Social change risk
•
• Legal change risk
•
 Real estate appraisal
• Real estate appraisal, property valuation or land
valuation is the practice of developing an
opinion of the value of real property, usually its
Market Value.
• The need for appraisals arises from the
heterogeneous nature of property as an
investment class: no two properties are
identical, and all properties differ from each
other in their location - which is one of the
most important determinants of their value.
• So there cannot exist a centralised Walrasian
auction setting for the trading of property
assets, as there exists for trade in corporate
stock.
• The absence of a market-based pricing
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• A real estate appraisal is generally
performed 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.
 Price versus value

A price obtained for a specific property under a



specific transaction may or may not represent

that property's market value: special
considerations may have been present, such as
Ø a special relationship between the buyer and
the seller,
Ø or else the transaction may have been part of a
larger set of transactions in which the parties
had engaged.
Ø Another possibility is that a special buyer may
have been willing to pay a premium over and
above the market value, if his subjective
valuation of the property (its investment
value for him) was higher than the Market
Value. An example of this would be the owner
of a neighbouring property who, by combining
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Ø Such situations often arise in corporate finance,
as for example when a merger or acquisition
is concluded at a price which is higher than
the value represented by the price of the
underlying stock. The usual rationale for
these valuations would be that the 'sum is
greater than its parts', since full ownership of
a company entails special privileges for which
a potential purchaser would be willing to pay.
Ø
Ø Similarly, such situations arise in real
estate/property markets as well. It is the task
of the real estate appraiser/property valuer to
judge whether a specific price obtained under
a specific transaction is indicative of Market
Value.
 Different types of
“value”
• There are several types and definitions of value sought by a
real estate appraisal. Some of the most common are:
• Market Value – The price at which an asset would trade in
a competitive Walrasian auction setting. Market Value is
usually interchangeable with Open Market Value or Fair
Value. International Valuation Standards (IVS) define
Market Value as:
• Market Value is the estimated amount for which a property
should exchange on the date of valuation between a
willing buyer and a willing seller in an arms-length
transaction after proper marketing wherein the parties
had each acted knowledgeably, prudently, and without
compulsion.

•
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• Investment value - is the value to one
particular investor, and is usually higher
than the market value of a property.
• Insurable value - is the value of real
property covered by an insurance policy.
Generally it does not include the site
value.
• Liquidation value -- may be analysed as
either a forced liquidation or an
orderly liquidation and is a commonly
sought standard of value in bankruptcy
proceedings. It assumes a seller who is
compelled to sell after an exposure period
which is less than the market-normal
timeframe.
 Value and Worth
• In Economics the ratio of the perceived value of
a capital asset vis-a-vis its intrinsic risk of
acquisition is termed 'worth'.
• `Clearly the lower the risk, the higher the
worth.
• It follows, therefore, that the perceived value -
or simply 'value' - of a real capital asset is the
total monetary worth obtained by reducing
exposure to risk and liability.
• Put in elementary terms, 'value' is the total net
benefit a buyer expects to receive from a
purchase, measured in currency.
• The measure of the 'value in exchange' of the
real estate transaction is the sales price.
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• In an economically efficient free market,
defined as a market where there are large
numbers of rational, profit-maximizers
actively-competing participants, with each
trying to predict future market values of
individual investments and where
important current information is almost
freely available to all participants,
competition leads to a situation where, at
any point in time, actual sales prices will
be a good estimate of value. It follows,
therefore, that sales prices of transactions
past are the best measure of value of
transactions to come.
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• Real Estate, however, is possibly the
inefficient market because different
participants may have varying amounts,
degree and quality of information.
• This offers an advantage to sellers and
helps explain the reason why properties
offered for sale are typically overpriced.
• Furthermore, the uniqueness of each
property compounds such inefficiency
even further.
• A problem, therefore, arises as it relates to
the determination of value, and the
solution is in function of the real capital
Approaches to appraisal
of R.E
 The cost approach
• The cost approach was formerly called the summation
approach.
•
• The theory is that the value of a property can be estimated
by summing the land value and the depreciated value of
any improvements.
•
• The value of the improvements is often referred to by the
abbreviation RCNLD (reproduction cost new less
depreciation or replacement cost new less depreciation).
Reproduction refers to reproducing an exact replica.
Replacement cost refers to the cost of building a house
or other improvement which has the same utility, but
using modern design, workmanship and materials. In
practice, appraisers use replacement cost and then
deduct a factor for any functional disutility associated
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• In most instances when the cost approach is
involved, the overall methodology is a hybrid
of the cost and sales comparison approaches.
For example, while the replacement cost to
construct a building can be determined by
adding the labour, material, and other costs,
land values and depreciation must be derived
from an analysis of comparable data.
•
• The cost approach is considered reliable when
used on newer structures, but the method
tends to become less reliable for older
properties. The cost approach is often the
only reliable approach when dealing with
special use properties (e.g. -- public
assembly, marinas).
 The sales comparison
approach
•
• The sales comparison approach 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 state licensed real estate appraiser
attempts to interpret and measure the
actions of parties involved in the
 Steps in the Sales
Comparison Approach


1. Research the market to obtain information

pertaining to sales, listings, 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.
 The income capitalization
approach
• Referred to simply as the "income approach“ is
used to value commercial and investment
properties. Because it is intended to directly
reflect or model the expectations and
behaviours of typical market participants, this
approach is generally considered the most
applicable valuation technique for income-
producing properties, where sufficient market
data exists to supply the necessary inputs
and parameters for this approach.
•
• In a commercial income-producing property this
approach capitalizes an income stream into a
value indication.
• This can be done using revenue multipliers or
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• The Net Operating Income (NOI) is gross potential
income (GPI), less vacancy and collection loss
(= Effective Gross Income) less operating
expenses (but excluding debt service, income
taxes, and/or depreciation charges applied by
accountants).
• Alternatively, multiple years of net operating
income can be valued by a discounted cash
flow analysis (DCF) model. The DCF model is
widely used to value larger and more expensive
income-producing properties, such as large
office towers. This technique applies market-
supported yields (or discount rates) to future
cash flows (such as annual income figures and
 Conclusion


As new data and business process



standards are developed, appraisers

must adapt to those standards, using
these standards how every appraiser
can meet the needs of a dynamically
changing market - both domestically
and globally - in real time.