Real Estate Exam: Property Valuation, Appraisal Methods, CMA, Market Value

Market value is the most probable price a property would bring in a competitive and open market under fair sale conditions, where both buyer and seller are well-informed, acting without undue pressure, and allowed reasonable time to find a buyer. Market price is the actual amount paid for a property in a specific transaction, which may be higher or lower than market value due to factors like urgency, emotional attachment, or lack of information. An appraisal estimates market value. The purchase price recorded on the deed reflects market price.

The three approaches are the sales comparison approach, the cost approach, and the income capitalization approach. The sales comparison approach compares the subject property to recently sold similar properties with adjustments for differences. The cost approach estimates the cost to replace the improvements minus depreciation, plus the land value. The income approach estimates value based on the net income the property generates, divided by a capitalization rate.

The sales comparison approach values a property by comparing it to recently sold similar properties, called comparables or comps. The appraiser selects three to five recent sales in the same area with similar size, age, condition, and features. Adjustments are made to the comparable sale prices to account for differences: if a comp has a feature the subject lacks, its price is adjusted downward, and if the subject has a feature the comp lacks, the comp's price is adjusted upward. The adjusted prices indicate a value range for the subject property.

The income capitalization approach estimates property value by dividing the net operating income by a capitalization rate. Net operating income is gross rental income minus vacancy losses and operating expenses, excluding mortgage payments. The capitalization rate reflects the expected rate of return for similar investments in the market. For example, a property generating 50,000 dollars in net operating income with a market cap rate of 8 percent would be valued at 625,000 dollars.

The cost approach estimates property value by calculating the cost to build a new replacement structure, subtracting accrued depreciation, and adding the value of the land. It is most reliable for new or nearly new construction, unique properties like churches and schools that rarely sell, and insurance purposes. The formula is reproduction or replacement cost minus depreciation plus land value equals property value. Reproduction cost replicates the exact structure with the same materials, while replacement cost builds an equivalent structure using modern materials and methods.

The three types are physical deterioration, functional obsolescence, and external or economic obsolescence. Physical deterioration is wear and tear from age and use, like a worn roof or faded paint, and can be curable or incurable depending on repair cost. Functional obsolescence results from outdated design or features, such as a home with only one bathroom or an obsolete floor plan, and may be curable or incurable.

A comparative market analysis, or CMA, is an informal estimate of a property's value prepared by a real estate agent to help sellers set a listing price or buyers determine an offer price. It uses recently sold comparable properties similar to the sales comparison approach but is less rigorous than a formal appraisal. A CMA is not performed by a licensed appraiser and does not follow the Uniform Standards of Professional Appraisal Practice. An appraisal is a formal, licensed opinion of value required by lenders before approving a mortgage.

The principle of substitution states that a rational buyer will pay no more for a property than the cost of acquiring an equally desirable substitute, whether through purchasing a comparable property or building a new one. This principle underlies all three appraisal approaches: the sales comparison approach assumes buyers compare similar properties, the cost approach assumes buyers would consider building new, and the income approach assumes investors compare returns across similar investments.

Highest and best use is the reasonably probable use of a property that results in the highest value, provided that use is physically possible, legally permissible under zoning and deed restrictions, financially feasible to produce income or value, and maximally productive among all feasible uses. Appraisers analyze highest and best use for both the land as if vacant and the property as currently improved. A commercial lot with a small house might have its highest and best use as a retail site.

The Uniform Standards of Professional Appraisal Practice, or USPAP, is the set of quality control standards for real estate appraisal developed by the Appraisal Standards Board of the Appraisal Foundation. USPAP establishes ethical rules, standards of competency, and reporting requirements that all licensed and certified appraisers must follow. It requires appraisers to be independent, objective, and impartial, and to produce credible and supportable opinions of value. ---