Valuation Process PDF

UNIT II: The Valuation Process  2.1 Introduction  The valuation process is a systematic procedure that an appraiser follows to provide answers to a client’s questions about real property value.  It is a model that can be adapted to a wide variety of questions that are related to value.  It...

UNIT II: The Valuation Process  2.1 Introduction  The valuation process is a systematic procedure that an appraiser follows to provide answers to a client’s questions about real property value.  It is a model that can be adapted to a wide variety of questions that are related to value.  It is a systematic and logical method of collecting, analyzing, and processing data into intelligent and well reasoned value estimates.  The valuation process begins when the appraiser agrees to take an assignment and ends when the conclusions of the appraisal are reported to the client. 1  Cont…  Each property is unique, and opinions of many different types of value can be developed for a single property.  The most common appraisal assignment is performed to extract an opinion of market value.  The valuation process contains all the steps appropriate to this type of assignment. 2  2.2 Steps of Valuation Process  The valuation process is accomplished through specific steps.  The number of steps followed depends on the nature of the appraisal assignment and the available data.  Research begins after the appraisal problem has been defined and the scope of work required to solve the problem has been identified.  After defining the problem and scope of work, the appraiser starts the research phase.  This is where they gather the necessary information to support the valuation.  The analysis of data relevant to the problem starts with an investigation of trends observed at the market level: international, national, regional, or neighborhood. 3  Cont…  This investigation helps the appraiser understand the interrelationships among: The principles, Forces, and Factors that affect real property value in the specific market area.  Such trends may include positive or negative percentage changes in property value over a number of years.  In assignments to develop an opinion of market value, the ultimate goal of the valuation process is a well-supported value conclusion that reflects all of the pertinent factors that influence the market value of the property being appraised. 4  Cont…  To achieve this goal, an appraiser studies a property from three different viewpoints which are referred to as the approaches value.  These three approaches are: Cost approach Sales comparison approach Income capitalization approach  Cost Approach: value is estimated as the current cost of reproducing or replacing the improvements (including an appropriate entrepreneurial incentive or profit) minus the loss in value from depreciation plus land or site value. 5  Cont…  In the Sales comparison approach: value is indicated by recent sales of comparable properties in the market.  In the income capitalization approach: value is indicated by a property’s earning power, based on the capitalization of income.  The income capitalization approach is the dominant approach when estimating the value of any income producing type of property.  It assumes a property’s value is determined solely by its expected future cash flows.  The three approaches are interrelated, each requires the collection and analysis of data the pertains to the property being appraised. 6  Cont…  From the approaches applied, an appraiser drives separate value estimates for the property being appraised.  One or more of the approaches may not be applicable to a specific assignment or may be less reliable to that assignment due to The nature of the property The needs of the client or Data available  The important steps in the valuation process are shown in the figure below. 7 8  Step 1. Definition of the problem  The definition of the problem should include the following: Identification of the client and intended users of the appraisal. Intended use of the appraisal  the idea of "Identification of the client and intended users of the appraisal" in valuation is crucial for ensuring the appraisal is relevant, unbiased, and meets the specific needs of those involved Purpose of the appraisal (including the definition of value) Date of the opinion of value Identification of the characteristics of the property (including its location, the property rights to be valued, and other features). Extraordinary assumptions Hypothetical conditions 9  Cont… Identification of the client and intended users of the appraisal  The valuation process begins before the client even engages the appraiser.  The valuation process is not just a linear sequence of steps but involves a broader context and understanding that starts even before the appraiser is formally hired.  In deciding whether or not to take on assignment, the appraiser must consider the client and any other professional obligations that the assignment will bring. The appraiser must clearly identify the client and, Intended users of the appraisal 10  Cont…  Even if the client wishes to remain unspecified, the appraiser must still identify the client in the work file for the assignment.  Identifying the client and other intended users leads directly To identifying the intended use of the appraisal, which in turn is an integral part of determining the scope of work. Intended Use of the Appraisal  The intended use of an appraisal is the manner in which the client will use the information contained in the appraisal report.  The client may specify the intended use of the appraisal when requesting it; if not the appraiser may have to solicit this information. 11  Cont…  An opinion of value may be needed to determine the following decisions involving real property: Price at which to buy or sell Amount of a loan Basis for taxation Terms of a lease Value of real property assets in financial statements Basis for just compensation during expropriation Other information useful in decision-making involving real property. 12  Cont…  To avoid wasted effort, the appraiser and the client must reach to a mutual understanding Concerning the intended use of the appraisal report and its conclusions and Who will own the final value estimate. Purpose of the Appraisal  The purpose of an appraisal is usually to develop an opinion of a certain type of value.  Types of appraised value include the following: Market value Use value Going-concern value Investment value Assessed value 13  Cont… Date of the opinion of value  The date of the opinion of value must be specified because the forces that influence real property value are constantly changing.  An opinion of value is considered valid only for the exact date specified.  Market value is generally seen as a reflection of market participants' perceptions of future economic conditions.  These perceptions are based on market evidence at a specific point in time.  The date of the opinion of value should not be confused with the date on the letter of transmittal, which is usually a different date. 14  Cont…  Economic conditions at a particular time, and sudden changes in business and real estate markets can dramatically influence value.  Most appraisals call for a current opinion of value, but in some cases a valuation as of a date in the past or in the future may be required.  Retrospective appraisals, appraisals as of a date in the past, may be required for Inheritance tax- date of death Insurance claims- date of casualty Income tax- date of acquisition Court cases- date of loss Other purposes 15  Cont…  Prospective appraisals, appraisals as of a future date, may be required to render an opinion of the likely value of property interests in The proposed developments or The value at the end of a cash flow projection.  In such cases care must be taken to avoid the implication that a future value opinion is market value.  Appraisers may be employed to derive an opinion of prospective value that will be used by Owners, Buyers, Investors, or Lenders to make decisions relating to real estate 16  Cont… Identification of the Characteristics of the Property  The appraisal problem cannot be properly defined without certain information about the subject property.  The essential items to identify the nature of the property are: Location and physical, legal, and economic attributes Real property interests to be valued (e.g., fee simple, fractional interest, etc…) Items included in the appraisal other than real property (e.g., personal property or trade fixtures) Restrictions on land use such as easements and leases. 17  Cont… Extraordinary assumptions and Hypothetical Conditions  To describe the scope of required in an assignment, the appraiser must first identify any extraordinary assumptions and hypothetical conditions affecting the appraisal.  It refers to situations where the appraiser must make assumptions or consider hypothetical scenarios that deviate from the typical market conditions or the property's current state.  This is often necessary when there is: 1. Lack of Market Data 2. Unusual Property Characteristics 3. Hypothetical Scenarios:  Extraordinary assumptions presume uncertain information to be factual. If found to be false these assumptions could alter the appraisers opinion or conclusion. Example: Consider an appraiser of a warehouse property that may be subject to environmental contamination. Even though the presence of contamination is suspected, it is possible for the appraiser to be based on the an extraordinary assumption that the property is not contaminated. 18  Cont… This appraisal analysis and opinion of market value are subject to building the 2,000 square meter on this vacant land as described in the blueprint on a date six months from now. This appraisal is subject to obtaining the right and ability to be connected to the sewer and water utilities. This appraisal is subject to remodeling the kitchen per the plans and specifications provided.  Hypothetical conditions are contrary to what exists, but the conditions are asserted by the appraiser for the purpose of the analysis. For example, in the case of a manufacturing plant that is known to be subject to environmental contamination, it is possible for the appraisal to be based on the hypothetical condition that it is not contaminated. 19  Step 2: Scope of Work  The scope of work is the amount and type of information researched and the analysis applied in an assignment.  The appraiser is responsible for determining the appropriate scope of work in the appraisal assignment, given The client's intended use and The nature of the problem to be solved.  In the appraisal report, the scope must be clearly disclosed.  It is often important for the appraiser to indicate what was not done in the appraisal. 20  Cont…  The appraiser may want to indicate the time spent and the area searched to gather the data, especially if only limited data was available.  While it is possible to describe the scope of work in various sections of the appraisal report, it is best to include a separate section for this topic.  Defining the scope of work helps the appraiser to identify Resources and Data that will be needed in the assignment  This preliminary analysis helps the appraiser to plan the subsequent steps in the valuation process. 21 Step 3: Data Collection and Property Description  Following the preliminary analysis (i.e., the identification of the appraisal problem and determination of the scope of work), the appraiser should collect data on The market area, The subject property, and Comparable properties in the market  The data needed by appraisers can be divided into 1. General data and 2. Specific data  General data includes information about trends in the social, economic, governmental, and environmental forces that affect the value of the property in the defined market area. 22  Cont…  General data can contribute significantly to an appraiser's understanding of the marketplace.  Specific data relates to the property being appraised and to comparable properties. This data includes Legal, Physical, Locational, Cost, and Income and expense information about the properties and the details of comparable sales. 23  Cont…  Financial arrangements that could affect selling prices are also considered  Data on comparable properties can be either General data that an appraiser has on file or Specific data that must be gathered for a particular assignment.  More often, comparable property’s data is specific supply and demand data that relates to the competitive position of property similar to the subject in its future market. 24  Cont…  Supply data includes Inventories of existing and proposed competitive properties, Vacancy rates, and Absorption rates.  Demand data may consist of Population, Income, Employment, and Survey data pertaining to potential property users.  From this data an estimate of future demand for the present or prospective use or uses of the subject property is developed. 25  Cont…  The amount and type of data collected for an appraisal depend on the approaches used to develop an opinion of value and the defined scope of work.  In a given valuation assignment, more than one approach to value is usually appropriate and necessary to arrive at a single value estimate.  Depending on the problems to be addressed, one approach may be given greater emphasis than others in deriving the final opinion of value. 26  Cont…  In conducting a particular assignment, the appraiser’s judgment and experience, the quantity of data and the quality of data available for analysis may determine which approach or approaches are used  The data collected should be meaningful and relevant.  All pertinent value influences, facts, and conclusions about trends should be clearly indicated in the report and related specifically to the property being appraised. 27  Step 4: Data Analysis  Once the appropriate data on the market area, subject property, and site has been collected and reviewed for accuracy, the appraiser begins the process of data analysis.  It has two components. These are: 1. market analysis and 2. highest and best use analysis 4.1 Market Analysis  Market analysis is defined as a study of market conditions for a specific type of property.  Broad market conditions provide the background for local and neighborhood market influences that have direct impact on the value of the subject property. 28  Cont…  Market analysis serves for two important functions. First, it provides a background against which local developments are considered. Second, knowledge of the broad changes that affect supply and demand gives an appraiser an indication of how values change over time.  Market analysis yields the information needed to use each of the three traditional approaches to value.  In the cost approach, market analysis provides the basis for adjusting the cost of the subject property for depreciation, i.e., physical deterioration and functional and external obsolescence. 29  Cont…  In the income capitalization approach, all the necessary income, expense, and rate data is evaluated in light of the market forces of supply and demand.  In the sales comparison approach, the conclusions of market analysis are used to the market and thereby identify comparable properties.  The extent of market analysis and the level of details appropriate for a particular assignment depend on the appraisal problem under examination 30  4.2 Highest and Best Use Analysis  Analysis of the highest and best use of the land; as though vacant and the property as improved is essential in the valuation process.  Through highest and best use analysis, the appraiser interprets the market forces that affect the subject property and identifies the use or uses on which the final opinion of value is based.  Analyzing the highest and best use of the land helps the appraiser identify comparable properties.  Potentially comparable properties that do not have the same highest and best use are usually eliminated from further analysis. 31  Cont…  Estimating the land's highest and best use as though vacant is a necessary part of deriving an opinion of land value.  There are two reasons to analyze the highest and best use of the property as improved. The first is to help identify potentially comparable properties. The second is to decide which of the following options should be pursued: Maintain the improvements as is. Cure items of deferred maintenance and retain the improvements. Modify the improvements (e.g., renovate, modernize, or convert). Demolish the improvements. 32  Step 5: Land Value Opinion  Land valuation is directly related to highest and best use analysis.  What do you think is the difference between land and site from appraisers’ point of view? Land includes the earth’s surface, both land and water, and anything that is attached to it, whether by the course of nature or by human being. Site refers to land that is improved so that it is ready to be used for a specific purpose  Land value can be a major component of total property value. 33  Cont…  Appraisers often develop an opinion of land value separately, even when valuing properties with extensive building improvements.  Land value and building value may change at different rates because improvements are almost always subject to depreciation.  For many appraisals, a separate opinion of value is required. Step 6: Application of the Approaches to value  The three important methods/approaches to property value are: 1. Cost approach 2. Sales comparison approach 3. Income capitalization approach 34  Cont… 6.1 Cost Approach  In the cost approach, Value of a property = Estimated land/site value + The current cost of constructing a reproduction or replacement for the improvements + Entrepreneurial profit and/or incentive _ Amount of depreciation in improvements 35  Cont…  This approach is particularly useful in valuing new or nearly new improvements and properties that are not frequently exchanged in the market..  The current costs to construct the improvements can be obtained from cost estimators, cost manuals, builders, and Contractors  Depreciation is measured through market research and the application of specific procedures.  Land value is estimated separately in the cost approach. 36  6.2 Sales Comparison Approach  The sales comparison approach is most useful when a number of similar properties have recently been sold or are currently for sale in the subject property's market.  Using this approach, an appraiser produces a value indication by comparing the subject property with similar properties, called comparable sales.  The sale prices of the properties that are judged to be most comparable tend to indicate a range in which the value indication for the subject property will fall. 37  Cont…  The appraiser estimates the degree of similarity or difference between the subject property and the comparable sales by considering various elements of comparison: Real property rights conveyed Financing terms Conditions of sale Expenditures made immediately after purchase Market conditions Location Physical characteristics Economic characteristics Use/zoning 38  6.3 Income Capitalization Approach  In the income capitalization approach, the present value of the future benefits of property ownership is measured.  A property's income and resale value upon reversion may be capitalized into a current value.  There are two methods of income capitalization: 1. direct capitalization and 2. yield capitalization. 1. In direct capitalization, the relationship between one year's income and value is reflected in either a capitalization rate or an income multiplier. 39  Cont… 2. In yield capitalization, the relationship between several years' stabilized income and a reversionary value at the end of a designated period is reflected in a yield rate.  The most common application of yield capitalization is Discounted Cash Flow (DCF) analysis.  The specific data that an appraiser investigates in the income capitalization approach might include the property's gross income expectancy, expected reduction in gross income caused by vacancy and collection loss, anticipated annual operating expenses, the pattern and duration of the property's income stream, and the anticipated reversionary value. 40  Cont…  After income and expenses are estimated, the income streams are capitalized by applying an appropriate rate or factor and convert into present value through discounting. Step 7: Final Reconciliation of Value Indications  The final analytical step in the valuation process is the reconciliation of the value indications derived into a single monetary figure or a range of values in which the value will most likely fall.  The nature of reconciliation depends on the appraisal problem, the approaches that have been used, and the reliability of the value indications derived 41  Cont…  The final opinion of defined value, which is the goal of the valuation process, is usually reported as a single figure or as a range of value or as a value in relation to some stated benchmark amount (i.e., more than or less than a given dollar amount). Step 8: Report of Defined Value  The assignment is not complete until the conclusion is stated in a report and presented to the client.  The reported value is the appraiser's opinion and reflects the experience and judgment that has been applied to the study of the assembled data. 42  Cont…  The appraisal report is the tangible expression of the appraiser's work and the last step in the valuation process.  The conclusions of an appraisal may be communicated to the client in writing or orally. 43  o u! k Y h a n T 44