Appraisal 101
The Art and Science of Property Valuation
October 26th, 2011
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WHY DO WE NEED APPRAISALS?
Real estate is different from stocks, bonds and other types of investments that are traded
frequently in a transparent manner.
Real estate is:
- Unique
- Immobile
- Illiquid
- Durable
- Expensive
Appraisals are needed to analyze the
specific attributes of a property and relate it
to the marketplace
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WHO USES APPRAISALS?
Owners (Financial Institutions, Pension Funds, Public Companies, REITS, Private
Investors):
- Assets marked-to-market on a monthly, quarterly, annual basis
- Accounting (IFRS) requirements
- Litigation
Real Estate Advisors:
- Acquisition and disposition analysis/ due diligence
Developers:
- Highest and best use analysis
- Feasibility analysis
- Construction financing requirements
Lenders:
- Mortgage financing
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WHO USES APPRAISALS? (CONT)
Government:
- Land expropriations
- Property assessment appeals
Tenants:
- Rental arbitrations
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WHO DOES APPRAISALS?
An appraiser is a real estate professional who provides an opinion of value of various types of
properties, and is typically accredited with the Appraisal Institute of Canada:
- AACI for commercial properties
- CRA for residential properties
May be a Fee or Non-Fee Appraiser
- Charges a fee based on the type or complexity of the property and purpose of the appraisal
assignment
- Non-Fee Appraisers may also undertake valuation work while working for insurance
companies, assessment authorities, banks, etc.
Requirements for AACI accreditation:
- University Degree or UBC Post Grad Certificate in Real Property Valuation
- Practical work experience
- Is insured through AIC
- Not in breach of the AIC appraisal standards (CUSPAP) and Code of Ethics
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WHAT IS AN APPRAISAL?
Supportable or defensible estimate or opinion of value
An impartial, expert and reasoned conclusion based
on an analysis of all relevant evidence in the market and
presented in the report
It represents the appraiser’s perception of the most
likely and most probable dollar value of the appraised
interest(s), subject to the qualifying conditions imposed
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KEY ELEMENTS OF AN APPRAISAL:
An appraisal must:
- Identify the client and other intended users, by name
- Identify the intended use of the report (Purpose)
- Identify the subject property by address and legal description
- Provide a definition of market value
- Identify the type of report: current, retrospective, prospective or update
- Provide a date of valuation
- Identify all assumptions and limiting conditions, and hypothetical conditions (if any)
Examples:
- the existing use is a legally conforming use
- legal title is free and clear of financial encumbrances
- building areas and site areas are correct
- soil conditions and building improvements are structurally sound
- no environmental contamination
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KEY ELEMENTS OF AN APPRAISAL:
An appraisal must (cont):
- Identify the nature of the interest being appraised; Leased Fee, Fee Simple or Leasehold
- Provide a physical description of the subject property and surrounding neighbourhood. Note
the date of inspection
- Provide an analysis of Highest and Best Use
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DEFINITION OF MARKET VALUE:
The most probably price which a property should bring in a
competitive and open market under all conditions requisite to a
fair sale, the buyer and seller each acting prudently and
knowledgeably, and assuming the price is not affected by
undue stimulus.
Implicit in this definition is the consummation of a sale as of a
specified date and the passing of title from seller to buyer
under conditions whereby:
1. The buyer and seller are typically motivated;
2. Both parties are well informed or well advised, and acting in
what they consider their best interests;
3. A reasonable time is allowed for exposure in the open
market;
4. Payment is made in terms of cash in Canadian dollars or in
terms of financial arrangements comparable thereto; and
5. The price represents the normal consideration for the
property sold, unaffected by special or creative financing or
sales concessions granted by anyone associated with the sale.
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HIGHEST AND BEST USE (“HABU”):
The foundation for all valuations, the definition of
Highest and Best Use is:
“The reasonably probable and legal use of vacant land
or an improved property, which is physically possible,
appropriately supported, financially feasible, and that
results in the highest value”
Appraisers need to determine the Highest and Best Use
“HABU” of the property as “improved” as well “as if
vacant”. The reason for this is that the existing use
may not represent HABU.
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HIGHEST AND BEST USE (“HABU”) (CONT):
Legal Permissibility
- Land is subject to Provincial regulations, Municipal planning and zoning constraints
- Encumbrances on Title: restrictive covenants, rights of way, environmental covenants,
leases, easements, heritage designation
Physical Possibility
- Land is constrained by its physical attributes: size and shape, accessibility, topography,
soil conditions, available services, environmental considerations
Financial Feasibility
- The HABU must be economically feasible within the context of the existing marketplace
(unless there is a hypothetical condition identified in the report)
Maximum Profitability
- More than one option can be economically feasible. An appraiser should determine
which is the most profitable.
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HIGHEST AND BEST USE (“HABU”) (CONT):
Issues/ Examples:
Zoning may allow for development of an office building but the project may not be
financially feasible at this time. HABU may be as a holding property.
Multi-family development versus office development
in downtown Vancouver
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THE THREE APPROACHES TO VALUE:
1. Income Approach
2. Direct Comparison Approach
3. Cost Approach
The approach used is dictated by the market, not
by the appraiser
Usually required to undertake at lease two of
the three approaches
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INCOME APPROACH TO VALUE:
Based on the assumption that a purchaser of income-producing real estate uses the
current and future income generating potential as a measure of value
The value of a property is related to the present worth of the
future income stream that it is capable of producing
Two methods under the Income Approach:
1. Direct Capitalization Approach
2. Discounted Cash Flow Approach
Investors typically will use both approaches,
applying a different weight to each method
based on the particular characteristics of the
investment
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DIRECT CAPITALIZATION APPROACH TO VALUE:
Direct Capitalization Approach takes a single year of income and converts that income
into a value expectation
Typically used on properties that are stabilized (i.e. essentially fully leased and at market
rents)
Adjustments can be made for lease-up and over/ under market rent but determining
stabilized NOI can be somewhat subjective
The more adjustments required, the less reliable
the results
Direct Capitalization is also typically used for
smaller, non-institutional grade properties
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DIRECT CAPITALIZATION APPROACH TO VALUE (CONT):
OCR Approach to Value
Year 1
Year 1 Fully Leased Base Rental Revenue
$3,617,568
Plus: Year 1 Retail Sales Percent Revenue
$10,508
Plus: Year 1 Recovery Revenue
$1,847,271
Total Rent & Recovery Revenue
$5,475,347
Plus: Other Income
$0
Total Potential Gross Revenue (as if fully leased)
Less: General Vacancy & Credit Allowance
$5,475,347
3.25%
$177,949
Effective Gross Revenue (EGR)
$5,297,398
Less: Total Operating Expenses including Property Taxes
$1,860,363
Net Operating Income (as if fully leased)
$3,437,035
OCR
Estimate of Value (as if fully leased)
7.00%
$49,100,503
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DIRECT CAPITALIZATION APPROACH TO VALUE (CONT):
Final Value – Direct Capitalization
Estimate of Value as if Fully Leased
$49,100,503
Less: Tenant Inducements associated with vacant units
$0
Less: Lease Commissions associated with vacant units
$0
Less: Lost Scheduled Base Revenue during lease-up of vacant units
$0
Less: Lost Reimbursement Revenue during lease-up of vacant units
$3,638
Less: Present Value of Total Rent Abatements
Less: PV of Capital Expenditures
Estimate of Value
Plus: Present Value of Amortized Capital Expense Recoveries
$354,547
$48,742,319
$719,781
Adjusted Estimate of Value
$49,462,100
Rounded
$49,500,000
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DISCOUNTED CASH FLOW APPROACH TO VALUE:
Converts a series of cash flows into a current-day expression of value
The income to be generated is typically forecasted over a ten-year period, or the time
span which allows the majority of leases in place to expire or “roll-over” at market
Income is typically generated from two basic sources:
1. The cash flow received over the holding period; and
2. The future sale price (reversionary value) at the end of the holding period
A discount rate (or internal rate of return – “IRR”) is applied to these earnings to find their
present worth
The reversionary value is established by capitalizing the estimated NOI at the end of the
holding period by the Terminal Capitalization Rate (“TCR”)
The Terminal Value is also discounted to present date utilizing the established Discount
Rate
Discounted Cash Flow is typically used on larger, more complex assets where the buyer
profile is more sophisticated
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DISCOUNTED CASH FLOW APPROACH TO VALUE (CONT):
The following is a list of key variables used in a typical Argus model, sorted by three
categories:
1. Those variables which one would expect to vary considerably from market to market
(i.e. Vancouver vs. Montreal):
Direct Cap Rate and TCR
Discount Rate (i.e. IRR)
Market face rents
2. Variables which one would expect only minor variations from market to market:
Inflation rates
Lag vacancy (i.e. down time) during investment horizon
General vacancy during investment horizon
Tenant Improvement Allowances
Leasing commissions
3. Variables which one would “usually” expect to remain fixed from market to market.
Credit loss
Structural allowance
Renewal term (number of years)
Retention ratio
Investment horizon
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DISCOUNTED CASH FLOW APPROACH TO VALUE (CONT):
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DISCOUNTED CASH FLOW APPROACH TO VALUE (CONT):
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DISCOUNTED CASH FLOW APPROACH TO VALUE (CONT):
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DISCOUNTED CASH FLOW APPROACH TO VALUE (CONT):
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DISCOUNTED CASH FLOW APPROACH TO VALUE (CONT):
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DIRECT COMPARISON APPROACH TO VALUE:
The Direct Comparison Approach is based on the principal of substitution that maintains
that a willing and prudent purchaser will not pay more for a property than the cost to
acquire an equally desirable substitute property
Probably the most relevant approach for land and vacant properties which are most likely
to be acquired by a user
“User” value often higher than “investor” value – investor has to assume the risks and
costs of lease-up and maintaining occupancy
For an income property, the Direct Comparison Approach is mostly used as a secondary
approach or reasonability check (the “price per pound”)
Sales adjustments process under the Direct Comparison Approach is subjective. Some
factors to adjust for:
- Time/ date of sale/ market conditions
- Age and condition – physical characteristics
- Size and class
- Location
- Tenant profile
- NOI per sq. ft.
- Financing (above or below market mortgage)
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COST APPROACH TO VALUE:
The cost method of appraisal is based upon the principal of substitution:
No purchaser would be willing to pay more for a property than the cost of a new replica
property
This proposition leads to a second conclusion which declares that the replacement cost
of a new property sets the upper limit of market value
The general formula is: MV = L+B-D
Where:
MV = the market value of the property
L = the market value of the site, as if vacant, as of the date of valuation
B = the cost (new) of the structural improvements at the date of valuation
D = the accumulated depreciation for the improvements on the site
The Cost Approach is considered to be the least reliable approach to establish market
value
This approach is most applicable for:
- A new building with no depreciation
- A unique property (church, mosque, legislative or historic building)
- A subject property where there is no other comparable sales evidence
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VALUE RECONCILIATION AND CONCLUSION:
An appraiser may use more than one approach
to estimate Market Value
If the conditions from each approach are different,
then the values must be reconciled
The appraiser will utilize their judgment and
experience to determine their final estimate of
Market Value
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HOT TOPICS IN REAL ESTATE APPRAISAL:
Estimating value in a volatile market: economic uncertainty around the world has had
positive and negative impacts on Vancouver real estate
The low interest rate environment: will it continue? What happens to value if interest
rates rise?
Estimating value when there are no sale comparables (as in 2009)
Green Buildings: additional value?
Impact of new developments on existing
office building values
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