Finance_09 Instructor Materials.docx

9. Qualifying the Property Learning Objectives After completing this lesson, students should be able to… Explain the role of an appraisal in determining a property’s market value Describe how loan-to-value ratios affect the lender’s risk List the steps in the appraisal process Discuss the three basi...

9. Qualifying the Property Learning Objectives After completing this lesson, students should be able to… Explain the role of an appraisal in determining a property’s market value Describe how loan-to-value ratios affect the lender’s risk List the steps in the appraisal process Discuss the three basic methods for estimating a property’s value: sales comparison, replacement cost, and income Define the five elements that are considered when evaluating a property’s suitability as a comparable Understand the difference between replacement cost and reproduction cost List the three different types of depreciation Calculate a property’s value using a gross income multiplier Prevent and/or respond to problems caused by a low appraisal Suggested Lesson Plan 1. Give students Exercise 9.1 to review the previous chapter, “Qualifying the Buyer.” 2. Provide a brief overview of Chapter 9, “Qualifying the Property,” and review the learning objectives for the chapter. 3. Present lesson content: Lender’s Perception of Value – Appraisals and loan-to-value ratios Appraisal Standards The Appraisal Process EXERCISE 9.2 Appraisal process Appraisal Methods – Sales comparison method EXERCISE 9.3 Sales comparison method – Replacement cost method – Income method – Final value estimate EXERCISE 9.4 Types of depreciation Dealing with Low Appraisals – Preventing low appraisals – Request for reconsideration of value EXERCISE 9.5 Dealing with low appraisals 4. End lesson with Chapter 9 Quiz. Chapter 9 Outline: Qualifying the Property I. The Lender’s Perception of Value A. An underwriter will evaluate the property based on an appraisal: an estimate of the value of a property, performed by a professional appraiser B. An appraiser will focus on market value: the most probable price a property should bring in a competitive and open market where the parties act knowledgeably and without undue stimulus C. The lender focuses on the loan-to-value ratio: the relationship between loan amount and the property’s value 1. A higher LTV creates greater risk for a lender, since a buyer with a smaller downpayment is more likely to default 2. The LTV is based on either the sales price or the appraised value, whichever is lower 3. Lenders may be willing to make high-LTV loans but usually impose stricter qualifying standards to compensate for the higher risk II. Appraisal Standards A. To prevent unreliable appraisals, the federal government requires states to license and certify appraisers who perform appraisals for “federally related” loan transactions B. Some states require that all appraisers be licensed or certified C. Inflated appraisals played a role in the most recent mortgage and financial crisis; as a result, appraisal standards have been strengthened at both the federal and state level III. Appraisal Process A. There are eight steps in the appraisal process: defining the problem, determining the scope of work, collecting and verifying data, analyzing data, determining site value, applying the appropriate methods of appraisal, reconciling the results to arrive at a final value estimate, and issuing the appraisal report B. In some situations, an appraiser may perform an exterior-only inspection (“drive-by appraisal”) rather than a full inspection of the property, although this has become less common 1. Interior inspection required for FHA, VA, and higher-risk conventional loans EXERCISE 9.2 Appraisal process IV. Appraisal Methods A. Sales comparison method 1. Appraisers using the sales comparison method rely on the sales prices of comparable properties to estimate the value of the subject property 2. The sales comparison method uses the same principles as a competitive market analysis, although a CMA can use data from current listings and expired listings 3. To determine whether a recently sold property is comparable, an appraiser considers: the date of the sale, the location of the property, the physical characteristics of the property, the terms of sale, and the conditions of the sale 4. The sale should have occurred within the previous six months, although the appraiser may adjust the sales price for changes in value if the property was sold in a volatile market; older sales may be used in slow-moving markets 5. Comparable properties should be located in the same neighborhood and have similar size, design, and quality as the subject property 6. Comparable properties must have sold under normal market conditions: the buyer and seller are unrelated parties, fully informed and acting free of unusual pressure, and the property was on the open market for a reasonable period of time 7. If there are differences between the subject property and comparables, the appraiser may adjust the sales price of the comparables to reflect what they would have sold for were they more similar to the subject property 8. The appraisal report should include information about current market conditions; an addendum form may be used to supplement this information EXERCISE 9.3 Sales comparison method B. Replacement cost method 1. There are three steps in the replacement cost method: estimating the cost of replacing the improvements, deducting any depreciation, and adding the value of the land 2. The appraiser usually relies on the replacement cost (the cost of constructing a new building with equivalent utility) rather than the reproduction cost (the cost of building an exact replica using the same materials and techniques) 3. The easiest way to estimate the construction cost is the square foot method, in which the appraiser multiplies the estimated cost per square foot by the square footage of the building 4. There are three types of depreciation that must be estimated: physical deterioration, functional obsolescence, and external obsolescence 5. Depreciation may be considered curable or incurable, depending on whether correcting the problem adds more value than the cost of the repair; curable physical deterioration is known as deferred maintenance 6. An appraisal may be “as is,” which means the appraisal is based on the property in its current condition, or “subject to,” which means the appraisal is based on the property as if all deferred maintenance was cured C. Income method 1. Value under the income method is calculated by dividing a property’s annual net income by the rate of return an investor would expect from the property 2. For residential rental properties, an appraiser will use a simplified version of the income method called the gross income multiplier method 3. The appraiser finds value by multiplying the property’s rent by a multiplier indicated by the relationship between other properties’ rents and values 4. An appraiser should use the property’s economic rent (the rent the owner would receive if the property were currently available) rather than contract rent (the rent the owner currently receives) D. Final value estimate 1. The appraiser will reconcile the values indicated by the various appraisal methods to arrive at a final estimate of value 2. The result is not an average of the figures; the appraiser may give more weight to certain methods based on the type of property EXERCISE 9.4 Types of depreciation V. Dealing with Low Appraisals A. A low appraisal can terminate a transaction, since the lender will adjust its loan amount based on the property’s appraised value, requiring the borrower to come up with a larger downpayment B. A real estate agent can seek to prevent low appraisals 1. An agent should use a CMA to help the seller price the property correctly 2. The agent should avoid including personal property as part of the sales price C. If a low appraisal occurs, an agent may request a reconsideration of value by providing the lender with alternate comparables that suggest a higher value for the subject property EXERCISE 9.5 Dealing with low appraisals Exercises EXERCISE 9.1 Review exercise To review Chapter 8, “Qualifying the Buyer,” have students answer the following questions. 1. What are the three main categories regarding a person’s financial situation that an underwriter will consider? 2. Income is considered to have three dimensions. What are they? 3. Which of the following would be included in a loan applicant’s stable monthly income? Wages from temporary employment Social security benefits Year-end bonuses that have been received for ten years Self-employment income from a business started this year Dividends from investments Unemployment compensation 4. How is the net equity in a property calculated? Answers: 1. Credit reputation, income, and net worth 2. Quantity, quality (dependability), and durability (probability of continuance) 3. Stable monthly income: social security; bonuses for ten years; dividends Not stable monthly income: wages from temporary employment; self-employment income from new business; unemployment compensation 4. Start with market value, then subtract any liens and selling expenses EXERCISE 9.2 Appraisal process Discussion Questions: 1. A lender is willing to make a loan with an 80% LTV. The sales price is $210,000. The appraised value is $200,000. What is the maximum loan amount? 2. On the board, write the eight steps in the appraisal process in an incorrect order, as in the example below, then ask the students for the correct order. Collect and verify data Apply appraisal method(s) Issue appraisal report Determine site value Define the problem Reconcile results to get final value estimate Determine scope of work Analyze data Answers: 1. Lenders base the maximum loan amount on the sales price or the appraised value, whichever is less. $200,000 × 0.8 = $160,000. 2. Correct order: Step 1 is Define the problem. Step 2 is Determine the scope of work. Step 3 is Collect and verify data. Step 4 is Analyze data. Step 5 is Determine site value. Step 6 is Apply appraisal method(s). Step 7 is Reconcile results to get final value estimate. Step 8 is Issue appraisal report. Here’s the list in the incorrect order given in the question, with the correct step numbers added: Collect and verify data: Step 3 Apply appraisal method(s): Step 6 Issue appraisal report: Step 8 Determine site value: Step 5 Define the problem: Step 1 Reconcile results to get final value estimate: Step 7 Determine scope of work: Step 2 Analyze data: Step 4 EXERCISE 9.3 Sales comparison method Discussion Prompt: Indicate whether each of the following sales would be an appropriate comparable, and if so, whether any adjustment would be needed. 1. Sold 14 months ago and the market has been active since then 2. In same neighborhood as subject property, although almost half a mile away 3. Has two-car garage, while subject property has one-car garage 4. Seller financing included special incentives 5. Parties were related to each other Answers: 1. No – should not be used (in an active market, more recent sales should be available) 2. Yes – can be used 3. Yes – can be used, but adjustment will be needed 4. Yes – can be used, but adjustment will be needed 5. No – should not be used (price isn’t a reliable indication of market value) Activity: Ask students to evaluate their own house and the surrounding neighborhood as an appraiser might. (If they live in an apartment or condominium complex, they should examine a family member’s or friend’s house, if possible.) The “Key Considerations in a Sales Comparison Appraisal” list in the textbook can be used as a guide. For each item shown in bold type on the list, students should make some notes about that aspect of the house or the neighborhood. (A sentence or two for each one should be enough, and it isn’t necessary to use technical appraisal terminology.) To determine the square footage of the house (if they don’t already know it), they can measure its outside dimensions using a tape measure. EXERCISE 9.4 Types of depreciation Discussion Prompt: Which type of depreciation is at work in each of the following situations? Is the depreciation likely to be considered curable or incurable? 1. Outdated kitchen appliances and bathroom fixtures 2. Economic distress in surrounding neighborhood 3. Roofing needs replacement 4. Zoning changes allow new nearby industrial uses 5. Necessary to pass through living room to reach one of the bedrooms 6. Carpeting that’s in good condition but no longer in fashion Answers: 1. Functional obsolescence; curable 2. External obsolescence; incurable 3. Physical deterioration; curable 4. External obsolescence; incurable 5. Functional obsolescence; incurable 6. Functional obsolescence; curable EXERCISE 9.5 Dealing with low appraisals Match the correct term to each of the following statements. Personal property Appraiser Purchase price Comparable sales Loan officer Reconsideration of value 1. An appraised value below this amount may place the transaction in jeopardy. 2. An option that can be pursued after receiving a low appraisal, if evidence suggests a higher figure is appropriate. 3. Including this in the purchase agreement, rather than selling it in a separate transaction, may lead to a low appraisal. 4. Information a real estate agent can provide when asking an appraiser to reconsider his estimate of value. 5. The person from whom an agent should request the addresses of the comparables used if an appraisal comes in low. Answers: 1. PURCHASE PRICE. A low appraisal (a valuation below the price agreed to by the buyer and the seller) can jeopardize completion of the transaction. 2. RECONSIDERATION OF VALUE. After a low appraisal, the parties and their agents may ask the lender for a reconsideration of value, to preserve the transaction. 3. PERSONAL PROPERTY. A sales price that covers personal property as well as the real property is likely to be higher than the appraised value, because appraisers don’t include personal property when they’re appraising real property. 4. COMPARABLE SALES. The appraiser may use the agent’s CMA when reconsidering a low appraisal. 5. LOAN OFFICER. The agent should obtain this information from the loan officer or underwriter, not the appraiser (who has a fiduciary relationship with the lender and cannot disclose this information). Chapter 9 Quiz 1. A property’s maximum value is determined by the cost of obtaining an equally desirable property. This is known as the principle of: A. anticipation B. conformity C. contribution D. substitution 2. Lenders will base the loan amount on the: A. appraised value B. sales price C. appraised value or sales price, whichever is less D. appraised value or sales price, whichever is more 3. Which federal law requires appraisals used in federally related loan transactions to be performed by state-licensed or state-certified appraisers? A. Fair Credit Reporting Act B. Financial Institutions Reform, Recovery, and Enforcement Act C. Real Estate Settlement Procedures Act D. Truth in Lending Act 4. Which of the following loans would be considered the least risky to a lender? A. $80,000 loan for a $100,000 property B. $180,000 loan for a $200,000 property C. $255,000 loan for a $300,000 property D. $380,000 loan for a $400,000 property 5. Which of the following is the final step in the appraisal process? A. Apply the appropriate methods of appraisal B. Define the problem C. Issue the appraisal report D. Reconcile the results to arrive at a final value estimate 6. Which of the following is not one of the three basic methods of appraising real estate? A. Income method B. Replacement cost method C. Sales comparison method D. Square foot method 7. A key difference between an appraisal and a competitive market analysis is that a CMA may use _____, while an appraisal may not. A. current listings B. expired listings C. recent sales D. Either A or B 8. Which of the following is not one of the key factors in determining whether a recent sale is a suitable comparable? A. Conditions of sale B. Cost of construction C. Date of sale D. Location of property 9. An appraiser should make adjustments to compensate for inflationary or deflationary trends when using a comparable that sold in a market with: A. quickly falling prices B. quickly rising prices C. flat prices D. Both A and B 10. An appraiser finds that it would cost $380,000 to construct an exact replica of the subject property. This is an example of: A. depreciated cost B. replacement cost C. reproduction cost D. square footage cost 11. An older house has problems with peeling paint and warped siding. This is an example of: A. physical deterioration B. external obsolescence C. functional obsolescence D. incurable depreciation 12. The gross income multiplier method is appropriate primarily when valuing a/an: A. single-family residence used as a rental B. ten-unit apartment building C. office complex D. owner-occupied single-family residence 13. The subject property rents for $1,500 per month. A nearby property rents for $1,450 and sold for $290,000. Another nearby property rents for $1,550 and sold for $310,000. What is the subject property’s most likely value? A. $290,000 B. $295,000 C. $300,000 D. $310,000 14. The process of analyzing value indicators from the various appraisal methods in order to arrive at a final value estimate is known as: A. extraction B. interpolation C. reconciliation D. regression 15. To help avoid a low appraisal, a real estate agent should: A. present sellers with a well-researched CMA B. help sellers set a realistic listing price for their home C. ignore the value of any personal property when suggesting a listing price D. All of the above Answer Key 1. D. The principle of substitution states that a property’s value cannot exceed the cost of obtaining an equally desirable property. 2. C. The maximum loan amount is based on either the sales price or appraised value, whichever is less. 3. B. The Financial Institutions Reform, Recovery, and Enforcement Act (or FIRREA) requires the use of a state-licensed or state-certified appraiser in a federally related transaction. 4. A. The loan with the lowest loan-to-value ratio (in this case, the 80% loan of $80,000 for a $100,000 property) would be considered the least risky. 5. C. The final step in the appraisal process is to issue the appraisal report, which lists the data and explains the reasoning behind the final value estimate. 6. D. The square foot method is one particular method of estimating replacement cost, not a method of valuing property. 7. D. A competitive market analysis may include current listings or expired listings as well as recent sales. Appraisals are limited to recent sales of comparable properties. 8. B. The cost of construction is not relevant to the sales comparison approach. The five issues in identifying comparables are date of sale, property location, physical characteristics, terms of sale, and conditions of sale. 9. D. Markets with rapidly changing prices mean that all but the most recent of comparables require an inflationary or deflationary adjustment. 10. C. The reproduction cost of a building is the cost of building an exact replica. Most appraisers focus on the replacement cost, which is the cost of building improvements with equivalent utility. 11. A. Wear and tear that reduces the value of a property is considered to be physical deterioration. If the damage is not overly expensive to correct, the deterioration is considered curable (known as deferred maintenance). 12. A. The gross income multiplier method is a variation on the income method of appraisal and is generally used only when appraising residences used as rentals. 13. C. Both subject properties have gross rent multipliers of 200 ($290,000 ÷ $1,450 = 200; $310,000 ÷ $1,550 = 200). Multiply the subject property’s rent by 200 to find its value ($1,500 × 200 = $300,000). 14. C. The process of reconciliation allows an appraiser to arrive at one final value estimate out of the results of the various appraisal methods. 15. D. All of these are steps a real estate agent can take to help avoid a low appraisal.