There are three appraisal methods that are used in appraising property and they are cost approach, market data, and income approach (capitalization). The appraiser will then merge these methods into one appraisal and this is called reconciliation. We will now look in detail at these methods.
Cost Approach (Replacement Cost Approach) - We have already looked at this earlier in the course.
1st Replacement Cost - The cost of rebuilding the property with equivalent utility and with the same or similar materials and labor and value.
Calculating Depreciation - There are several different ways that we can calculate depreciation:
Straight Line Method - The first step is to take the economic life of a structure and place a 1 on top of it, which gives it an annual fractional amount.
Effective Age: Economic life can be increased by remodeling or good maintenance, "the effective age" can be better than it's actual age, would use it's effective age not it's actual age.
The cost approach takes a step-by-step procedure and calculates the value of each aspect of the property in question.
Vacant - The first step is to appraise the land as if it were vacant. This is done by comparing the price to other similar vacant lots. Lets say that the similar lots of similar shape and size are selling for $18,000.
Building Value - Add the value of rebuilding the building with improvements. Lets say the cost is $137,020. It is usually based on the contractor's charge for construction.
Substitution - A buyer would not pay more than the cost of building a brand new building for other buildings in the area. This is the principal of substitution.
Straight Line Depreciation - The depreciation method that is used in appraisal is always straight line. This is because we are working with an asset that in actuality deteriorates at a regular rate.
Accelerated Depreciation - When working with tax laws and regulations we can use accelerated depreciation. This is an income tax strategy and not property reality. The test will often times use these tax strategies as a wrong answer.
Book Losses - Prior to the 1987 tax reform act, accounts could use a book loss in excess of straight line depreciation. These wrong answers could include 125% or 150% of declining balance. There was also "double declining balance" or 200% of the straight line depreciation amount.
Grandfathered Properties - Properties being depreciated prior to 1987 might still enjoy these exceptions in that they are grandfathered investments & personal property that used 25 or 30 year depreciations.
Recapture- Under the past tax law, if a person took the accelerated depreciation and sold the property, they had to declare the excess deductions over straight line as income. This was known as recapture (of excess deductions).
Straight Line ONLY - These factors are no longer part of lives, but they could be on the test. Remember that appraisal only uses straight line depreciation.
The purpose of purchasing rental property is to provide NET income to the owner. The Appraisal Method that utilizes Net Income in determining value is called the Income Approach.
The Income Approach emphasizes value based on the NET income the rental or business will produce. The Income Approach is also known as CAPITALIZATION.
Income Approach (Capitalization) - This appraisal method is utilized in determining the income producing ability of the subject property. The Income (Capitalization) Approach is used with commercial property and rentals.
Method - This appraisal method considers the future benefits from the income producing power of the property or business. It bases the future income power on the present NET income and gives an estimate of the amount of RETURN ON INVESTMENT based on percentage desired by the buyer. This is known as the capitalization rate.
Value - The value of the property is equal to its capitalization rate. The capitalization or Cap Rate is a percentage chosen by the appraiser or buyer in determining the overall value of the rental or business.
Capitalization Rate Formula: PROPERTY VALUE = NET INCOME divided by the CAPITALIZATION RATE.
We will look at Income approach in later lessons.
Objective vs. Subjective Value
Objective vs. Subjective Value - These values are basically drawn by people within the real estate industry versus the seller's opinion of what the sale price should be.
Objective Value - This is the value drawn by outside sources that do not have an interest in the property. Appraisals and market surveys by real estate brokers are examples of objective value.
Subjective Value - This is value drawn by people who have an interest in the property such as the seller, heir to the property, holder of a life estate, etc. This is value "felt to be true" by a party of interest.
Depreciation may occur from:
A) economic obsolescence found in the neighborhood where a property is located
B) loss of functionality due to the basic construction techniques used in a building
C) loss in value due to deferred maintenance
D) all of the above
The method used to compute depreciation in appraisal is called:
D) straight line
The period over which a property may be profitably used is called its:
A) economic life
B) amortized life
C) income life
D) profit life
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