5.1 Appraisal Approaches and Methods (17 ) PDF

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Appraisal Review Manual 2015 5.1 Appraisal Approaches and Methods ____________________________________________________________________ In real estate appraisal, there are three (3) basic approaches for valuing property: 1 – Market Data Approach or “Sales Comparison” 2 – Cost approach 3 -- Income approach

Valuation Approach #1: The Market Data Approach ( “Sales Comparison” Approach) Basic concept: The Market Data approach is based on the economic principle of – Substitution — if a thing can be substituted for another, then their values will be comparable. Hence, the value of a property will be comparable to that of similar properties with similar qualities. The principle of Substitution 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 the Market Data Approach, the appraiser attempts to interpret and measure the actions of parties involved in the marketplace, including buyers, sellers, and investors. Before the advent of professional appraisers, the quick approach done by real estate agents for valuing real estate was to prepare a competitive market analysis (CMA). In a CMA the value of a property is estimated by comparing it to the sale price of similar properties in the same area. But a CMA is just a “snapshot” because not all similar properties are “exactly similar.” A CMA done by a real estate agent is not a formal and professional appraisal. It could also have a bias since a CMA done by a real estate agent aims to persuade an owner to sell the property at a target pricing level deem by the agent marketable. Thus a CMA can be a guide but should never be presented as an appraisal. The appraisal prepared by a professional appraiser which emulates the CMA method is formally called the “Market Data Approach.” It is also popularly known as the “Sales Comparison Approach.” The Market Data Approach is more sophisticated and reliable than just a CMA prepared by real estate agents. The Subject property is compared to recently sold comparable properties. However, because no two properties are exactly alike, the sales prices of the comparable properties are carefully analyzed and appropriately adjusted up or down for each of the differences between the subject property and the comparable properties. When comparing different properties, not just the physical differences in the properties, such as the actual structures, their ages and conditions, compared, but also what property rights are being transferred or were transferred in the comparable properties, and also any differences in encumbrances between them. For instance, is a fee simple title being transferred, or are there any easements or deed restrictions on the subject property or on the comparable properties? Data collection methods and valuation process The availability of market data is essential. Market data can be prices, costs, or offers. Market data is an indicator of market value which is defined as the most probable price at which the property will sell, not

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Appraisal Review Manual 2015 necessarily the average or the highest price. The market value is considered the cash price, so it does not take into consideration any financial incentives or financing arrangements. Data is collected on recent sales of properties similar to the Subject. Ideally, only SOLD properties may be used in an appraisal as they represent amounts actually paid or agreed upon for properties. However, in the Philippines, the source of reliable market data is limited. Although real estate transactions are required to be recorded with the BIR and the LGU for the payment of transaction taxes, these records are confidential and not available to the general public. Furthermore, many transactions are under-valued. Other alternative sources of reliable market data must therefore be found in the private sector -- 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 are not identical to the subject property, adjustments must 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. The adjustment is somewhat subjective and relies on the appraiser's training and experience. 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. It is possible for various appraisers to yield different indicators and these have to be reconciled. Terminologies 1) Subject – refers to the property to be valued. 2) Comparable – refers to other properties (the more the better) which can be compared “apple-to-apple” with the Subject because they have closely similar features. 3) Elements of comparison - are the various characteristics that are commonly comparable between the various properties being considered such as price, property rights, financing terms, conditions of sale, market conditions, location, physical and economic conditions, etc.. 4) Units of comparison – factors commonly found in the comparables, price per square meter; net income multiplier; etc.. 5) Market price - is the price that the comparable property was sold for; it may be more or less than the market value, particularly if either buyer or seller needed to complete the transaction quickly, or if the transaction was not at arm's length, such as a sale between relatives or friends. 6) Market cost - is what it would actually cost to buy the land and build the structures. Market value and market cost may not be the same; it is rarely the same for improvements to the property. For example, paying Php 200,000 to add a new addition probably will not increase the market value by Php 200,000. Market cost estimates are partially needed to make adjustment values upon comparables. Steps in the Market Data approach 1. Research the market to obtain information pertaining to sales, and pending sales that are similar to the subject property

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Appraisal Review Manual 2015 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 of the comparables. 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 (upward or downward) of the comparable sales into a single value indication Units of comparison – are the components or units that allow quantification of the elements of comparison. such as price per sq. meter, rent multiplier, income ratio; density measures; Example of Elements of comparison and Units: Unit 1. Location : Distance from amenity 2. Site specific data : a) High vantage point, nice view, etc. b) Agri land – existence of irrigation 3. Physical characteristics Number of bedrooms, garage, etc. 4. Allowed Use Level of commercial allowed C-1, C-2, etc. Height limit 5. Economic characteristics Land with coconut vs. fruit trees 6. Neighborhood data Surroundings clean, well-lighted, safe etc. 7. Conditions of sale Terms of payment, option, escrow, etc.

km. % % PhP value % or Php % or Php % or PhP % PhP value

Methods of Comparison There are two basic ways to compare market data between a Subject and a Comparable: 1) Review and intuition or “observation” method; and 2) Adjustment grid data analysis The Review and Intuition method is a simple approach. It does not require any deep analysis, just a simple comparison between the two properties. From experience, the Appraiser makes a value judgment and a declaration of value based on his observations past and present. It is intuitive, not testable. No serious computations are needed. The Adjustment grid method is a more sophisticated technique. It is systematic and minimizes risk. It is also more logical and allows the appraiser to back up his indicated value by presenting the logic he used in arriving at the estimate. The adjustment grid is a worksheet where the elements of comparison are arrayed and adjustments are made.

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Appraisal Review Manual 2015 The steps in the Adjustment Grid method are as follows: a) Comparables are arrayed in a table horizontally b) Common elements of comparison arrayed horizontally; usually price is given. c) Adjustment on value in terms of percentage or absolute amounts developed d) Adjustments are applied to make comparables similar to the subject property Adjustment rules:  If the comparable is inferior, the market price is adjusted upward, adjustment is “plus.”  If the comparable is superior, the market price is adjusted downward, adjustment is “minus.” The adjustment rules can be confusing. But the simple rational is this: The comparable’s value is adjusted to make it “equivalent” to that of the Subject property.  If a feature or element in the comparable property is inferior, then an adjusting value must be added to it to level up with the Subject.  If the feature or element is superior, then an adjusting value must be deducted from it to level down with the Subject.

To better understand this methodology, a simple example is presented below: Assignment: Appraiser was asked to value a 2BR house in a subdivision made by Camella. After doing research, he saw 3other 2BR homes of the same model, and lot sizes, with offering prices and features as follows – Chouse#1 – P2.5M; is one km from the park, has one-car garage and is 5 years old. Chouse#2 - P2.7M; is 1.5 km. from the park, has one-car garage, and is 2 years old. Chouse#3 - P2.6M; is 2 km from the park, has 2-car garage, and is brand new. From research, he found the homes have all the same lot size and the current value of the lot is P 1.2M. Proximity to the park which has a beautiful clubhouse is considered a premium and a half-km differential results in a 5% price differential. The current cost of building an extra one-car garage is P200,000. Assume a useful life of 50 years. Solution using the Adjustment Grid Method

Element of Comparison

Comp House#1

Comp House #2

Comp House #3

SUBJECT

1. 2. 3. 4.

P 2,500,000. 1.0 km One-car 5 years old

P 2,600,000. 1.5 km One-car 3 years old

P 2,700,000. 2.0 km Two-cars Brand new

To derive 1.0 km Two-cars 2 years old

ADJUSTMENTS 1. For distance to park 2. For garage 3. For age

0% (same as subj) Inferior + P200K Inferior +3x30K

Inferior +5% Inferior +P200K Inferior +1x30K

Inferior +10% Same, no adj. Superior -2x30K

Adjusted Values

P 2,790,000.

P 2,960,000.

P2,910,000.

Offer price (Asking) Location from park Garage Age of the house

Ave= P2,886,666.

Notes: 1. The lots of these houses currently sell for P 1.2M. From CHouse#3, a brand new home costs (P2.7-P1.2) = P1.5M 2. A depreciation period of 50 years is assumed. Thus average annual depreciation is P1.5M/50 or P30,000/year. Since the prices given are offering prices (ceilings), I recommend a 5% reduction for negotiation. Thus the indicative market value for the Subject House is 95% x P2.87M or about P 2,725,000.

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Appraisal Review Manual 2015 Valuation Approach #2 : The Cost Approach Concept of the Cost approach – The value of the Subject property can be estimated by developing a cost estimate of the property as if new and adjusting the said cost estimate for depreciation that reflects the current condition of the subject property. Wikipedia explains the Cost Approach in detail as follows: “The cost approach was once 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 (for "reproduction/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 almost always use replacement cost and then deduct a factor for any functional dis-utility associated with the age of the subject property. An exception to the general rule of using the replacement cost, is for some insurance value appraisals. In those cases, reproduction of the exact asset after a destructive event like a fire is the goal.”

The cost approach is therefore obviously suitable for valuing improvements, not land. However, in some instances, land can also be valued using the cost approach. For example, if the assignment is to value a developed residential subdivision project as a whole, then the cost approach will be applicable. The Appraiser can arrive at a value indication by obtaining the current value of raw land using market data and then making a current cost estimate for site development and deduct depreciation. For many assignments which will use the Cost approach, the overall methodology is a mix of the cost and market data approaches. For example, the replacement cost to construct a building can be determined by adding the labor, material, and other costs. On the other hand, land values must be derived from an analysis of comparable market data. The cost approach is considered most 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. The principle of Substitution is also applicable in the Cost Approach. STEPS in the Cost Approach: 1) Estimate land value (using market data or sales comparison) 2) Estimate cost to replace or reproduce improvements as if new 3) Deduct accrued depreciation. 4) Add the depreciated cost of improvements to the land value.

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Appraisal Review Manual 2015 Abbreviations and meanings: Reproduction cost new RCN Replacement cost new RCN D RCNLD

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A virtual replica, same design, same materials Comparable function and utility, equally satisfactory substitute Depreciation (accrued depreciation) Replacement cost new less depreciation

Components of Costs Market costs are the total of current prices of the factors of production – Labor, Materials, Management and Capital. Total costs can be broken down to direct costs, indirect costs, margin, and taxes. Direct costs – those which are directly related to the construction of the improvement; in essence, costs of the components and elements that have been installed into the completed structure, including the costs incurred to install them (labor, equipment, supplies, and supervision). Indirect costs – those which are associated with direct costs, such as design fees, permit fees, mobilization, office and administrative expenses, insurance premiums, etc. Indirect costs are also called overhead costs. It is often difficult to estimate indirect costs as these vary with the nature of the project and with the capability of the builder. However, industry factors of between 5 to 10% of direct costs are acceptable rates. Builder’s margin – in addition to direct and indirect costs, allowance must be made for the builder’s profit margin which can range from 10% to 20%. Taxes – also comprise part of costs. In the Philippines, all construction revenue are subject to value added tax of 12%. The output tax can however be reduced by corresponding input tax, thus the net effect of VAT will be in the range of 5 to 7%. Local taxes, nominally about 1 to 2% also come into play. Methods of Cost Estimating There are four generally acceptable methods for cost estimating: 1) 2) 3) 4)

Comparative area method Unit cost method Index method Quantity survey method

(1) Comparative Area Method – In this method, the cost is estimated from known construction cost of similar property expressed in terms of overall size or capacity (e.g. per square meter of floor area). (2) Unit cost method – unit costs for major cost groups are developed, using units such as the square meter, linear meter, etc. and applied to estimated group quantities. (2) Index method – if either overall costs or unit costs are historical values (old), indexing is applied to update them. Current cost is estimated by applying an adjustment factor, determined from a pertinent index, to original cost; also referred to as trending method. An index tracks relative changes in the price or cost of specific items or groups of items over a period of time.

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Appraisal Review Manual 2015 (4) Quantity survey method – measurement of the quantity and quality of all materials, labor, equipment, etc.. unit cost figures are applied to arrive at a total cost estimate. Add design fees, license, overhead, profits, tax. The process of cost estimating is a relatively technical and complex effort. The appraiser should consult and collaborate with an architect, engineer or quantity surveyor. Another viable and practical approach is to actually engage a builder to prepare a hypothetical quotation for the subject property as if it were to be completely rebuilt. Applying Depreciation to RCN After deriving the replacement cost new, it is necessary to deduct accrued depreciation from several factors: 1) Physical deterioration; 2) Functional obsolescence; 3) Economic obsolescence. 1) Physical Deterioration is due to wear and tear in operation and exposure to the elements. Depreciation in value due to physical deterioration is estimated by figuring out the cost of restoring worn-out components to brand new. 2) Functional Obsolescence is depreciation resulting from new technology, changes in design, materials or process and as a result the older parts of a building are found no longer functional, inadequate, expensive to maintain or operate. Examples: Old light fixtures are now supplanted by energy-saving LED, elevators are more power-efficient, expensive centralized air-conditioning can be replaced by split-type units, rust-prone iron window frames are now aluminum, etc.. (3) Economic (or Environmental) Obsolescence is depreciation resulting from influences external to the property itself such as - changes in the local economy, shifting property use pattern, legal changes, legislation ordinances, zoning and administrative orders, and the encroachment of objectionable influences such flooding, informal settlers, etc.. Physical deterioration and functional obsolescence are either “curable or incurable.” Curable obsolescence will require renovation costs. But incurable conditions can not be remedied and therefore will significantly cause a negative impact upon the estimate of replacement cost. Depreciation due to incurable conditions will definitely lower market value. Economic obsolescence which is incurable can only be measured by the market and income approaches. Steps/Methods of Estimating Depreciation 1) Market extraction method – depreciation is estimated from comparables; Method: from a comparable sale, deduct land value, obtain depreciated value of building; estimate RCN and compare to obtain depreciation; then compute current value of building. Example: The Subject is a 5-year old 2BR model on 100 sq.m. lot. Two compa...