Real Estate Appraisal & Financesurececourses.info/materials/CE/Electronic Books...banks borrow funds from their district federal reserve bank and pledge their commercial paper as collateral.

Real Estate Appraisal & FinanceBy

Dean Scherwinski

Table of Contents

This publication is designed to provide accurate up to date information, but is subject to revisions of local, state and federal laws, regulations and court cases. If there are any inconsistencies between this and current law, then the official

law prevails. This publication, author and publisher are not engaged in legal, accounting, or other professional advice and this publication should not be used as a substitute for them. If legal, accounting, or other professional advice or service is

needed, you should seek the services of a competent professional.

Special thanks for contributions made by: Mary Claire Sparrow and Philip Cali.

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Copyright© 2012 - 2014

Finance Introduction 1

Federal Reserve 1

Finance Basics 2

FHA Insured 3

VA Guaranteed 5

Default 7

Foreclosure 8

Deficiency Judgment 9

Credit Impact 10

Appraisal Introduction 10

Principals of Value 11

3 Approaches to Value 12

Reconciliation 14

Appraisal Process 15

FINANCE INTRODUCTIONWhen the economy is infused with more spendable cash, the possibility for increased spending activity is enhanced. Increased spending requires increased production. With increased production comes more jobs. More people are employed and spending money. Thus in the reverse situation, the withdrawal of funds from circulation would result in a slowdown of economic activity. The cost of money or interest charged for borrowed funds will directly affect this economic activity. The higher the cost, the lower the borrowing activity, and slower economic activity. Thus lowering interest rates would raise demand for borrowed funds and produce increased economic activity. Theoretically, manipulations of the supply and cost of money should result in economic balance. Although the efforts at balancing the economy are not always successful it does have a profound effect on real estate financing.

THE FEDERAL RESERVEThe Federal Reserve System (The FED) is this nation’s “monetary manager.” The Fed is charged with the maintenance of sound credit conditions to help create conditions favorable for employment, counteract inflationary and deflationary movements, plus stabilize values, growth of the nation, and rising levels of consumption. The FED was established in 1913 when President Woodrow Wilson signed the Federal Reserve Act. The act’s original purpose was to establish facilities for selling or discounting commercial paper and to improve the supervision of banking activities. Its full impact on our monetary system has broadened over time to include influence over the availability, credit, and cost of money (interest rates). As the central bank of the United States, the FED attempts to ensure that money and credit growth over the long run is sufficient to provide a rising standard of living for all U.S. citizens. In the short run, the FED seeks to adapt its policies in an effort to combat deflationary or inflationary pressures. And as a lender of last resort, it has the responsibility for utilizing policy instruments available to it in an attempt to forestall national liquidity crises and financial panics.

FUNCTIONS

The Fed has numerous functions, among which are issuing currency, supervising and regulating member banks, clearing and collecting their checks, and administering selective credit controls over other segments of the economy. However, the three functions most closely related to real estate finance are:

• Regulation of the amount of its member banks’ reserves: each of the Fed’s individual member banks is required to keep reserves equal to a specified percentage of the bank’s total funds on deposit with its federal district bank. These reserve requirements are designed to protect bank depositors by guaranteeing that their funds will be available when they need them. But even more important is the Fed’s ability to “manage” the national money market by adjusting the amount of reserves required from time to time. By raising the reserve requirement (and thereby limiting the amount of money available to the member banks for making loans), the Fed can frequently cool down a “hot” money market and slow the economic pace. By lowering the reserve requirements, the Fed can permit more money to enter a sluggish economy. Member banks can retain a larger percentage of their total assets, allowing more money to become available for loans.

• Determine discount rates: commercial banks operate primarily to finance personal property purchases and short-term business needs. The loans they issue are referred to as commercial paper. The Fed operates a market for selling this paper at a discount, providing member banks with additional funds for continued lending activity. This is done through what is referred to as the discount window, to control the money supply. When the window is open, money is added to the system, and vice versa. Although discounting commercial paper may appear to have little significance for real estate finance, the process enables members to expand their lending activities. The banks borrow funds from their district federal reserve bank and pledge their commercial paper as collateral. In effect, the Fed charges the borrowing bank interest on its loan. Thus, the individual bank has a basic or primary interest rate against which it can measure the rate (interest) it will charge its borrowers. The Fed discount rate is used by many major banks to set their prime rate, prime meaning simply the rate a commercial bank charges its most creditworthy customers or its “prime” customers. So the higher the Fed’s discount rate charged, the higher prime will be and consequently the higher the rate of interest to the real estate borrower. In mortgage lending, these discounts establish the base interest charges for short-term mortgage loans. Borrowers, depending on their credit standings, can expect to pay the prime rate or higher, as circumstances dictate. For example, construction loans may be secured from commercial banks at two points above prime, or 2% above the prime rate. Thus, by adjusting the rate of its discount, the Fed exerts a great deal of control over the amount of money or credit available throughout the system. When the Fed raises its discount rate, member banks slow their sales of commercial paper and obtain fewer additional funds. Therefore, less credit becomes available at the local level, and theoretically, the economy is slowed. The reverse process occurs when the discount rate is lowered.

• Open-market operations: the Fed relies on its open-market operations as another important tool to achieve its goal of balancing the economy. These activities involve the purchase or sale of government securities in lots, which

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consists primarily of United States Treasury issues, and also include securities issued by the federally sponsored housing and farm credit agencies, the Federal Home Loan Bank system, the Federal Housing Administration (FHA), and Ginnie Mae, to name a few. A decision by Federal Open Market Committee (FOMC) to buy or sell securities has an immediate and important impact on the availability of money for economic activities. When FOMC sells securities, the economy slows down, as money available for credit is withdrawn from the market. When FOMC buys securities, it is in effect pumping money into the economic system, thereby encouraging growth and expansion. The impact of these procedures on the availability of money for real estate is quite similar to the impact caused by raising or lowering the discount rate.

FINANCE BASICSIn good times lending activities increase to serve the growing demand. When the demand for mortgage money is great, local lenders may deplete available funds. A national mortgage market exists for this purpose. Fannie Mae, Freddie Mac, and Ginnie Mae are the major participants in a viable national market for real estate mortgages. They and other smaller operators, are collectively known as the secondary mortgage market. Loans created by local lenders, thrifts, banks, mortgage bankers, and others, known as the primary mortgage market (lenders where loans are originated) package the loans into mortgage pools which are purchased by the secondary mortgage market. Proportionate ownership of these mortgage pools is then sold to investors in the form of mortgage-backed securities (MBS). In this manner, the secondary mortgage market acts to stabilize the availability of funds for real estate throughout the country.

Real estate is a local market that it is fixed in place. The nature of the real estate finance can be described in three ways:1. Hypothecation: The borrower has Legal Title (is the legal owner and retains full legal rights) and the lender has

Equitable Title (an interest in the title of the property). The lenders security interest in the property is a typically a mortgage with no legal rights except upon loan default when the legal title may be attained through foreclosure.

2. Collateral: Pledging the property to back up the promise to repay the loan. The real estate is pledged through a mortgage by the borrower (mortgagor) to the lender (mortgagee) as the borrower’s guarantee that the terms of the promissory note will be satisfied.

3. Leverage: The use of other people’s money. In perspective a proportionately small amount or no money to secure a large loan for the purchase of a property. The amount financed in comparison to the value of the property determines the loan to value (LTV). With a smaller amount of personal money you have a higher LTV (e.g. 5% down payment is a 95% LTV). A larger amount of personal money means a lower LTV (e.g. 20% down payment is a 80% LTV). If down payment decreases the LTV and leverage increase. If the down payment increases then the LTV and leverage decrease. The LTV is always based on the sales price or appraised price which ever is lower.

The terms that most people have difficulty understanding are Mortgagor and Mortgagee. The borrower is the mortgagor and the lender is the mortgagee. It does not seem to make sense since the lender provides the money. The reason is that most people do not understand what a mortgage is. A mortgage is a legal document which provides the right to lien a property. The “or” (e.g. mortgagor) is the one giving something so the borrower is giving the right to lien the property to the lender, thus they are the mortgagor. The lender the mortgagee, “ee” the one who is receiving it that right. In return the lender then borrows the money through a promissory note, a completely different legal document. People do not get a mortgage they give a mortgage and get a mortgage loan. An easy way to remember this is borrower and mortgagor each have two “o’s”. Lender and mortgagee each have two “e’s”.

CREDIT

Just as important if not more important is credit and credit scores. Credit not only determines whether or not you can get a mortgage loan but also determines your interest rate. Years ago, credit was reviewed manually. An underwriter would pore over a credit report looking for any late payments, collection accounts, or bankruptcies. There was no true universal standard for a credit review but a mortgage could be declined if there were at least two late payments in the applicant’s recent history. That was until the introduction of credit scores in the mid 1990’s, sometimes called FICOs, the acronym for the firm that devised the credit scoring algorithm, Fair, Isaac Corporation.

Credit scores are not simply a requirement but they also affect your interest rate, required down payment, ability to qualify for Private Mortgage Insurance (PMI), and how much you can borrow. You can still get a mortgage with a lower credit score but it is much more difficult than in the past. Credit profiles are assigned a three-digit number ranging from as low as 300 to as high as 850. The higher the number would imply the less likelihood of mortgage default so in turn

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the better the credit, the lower the rate, and the lower the required down payment. A lower score would require a higher interest rate and/or larger down payment. Most loan programs require a minimum credit score of 620 for a loan approval with the best interest rate options reserved for those with credit scores above 740. The interest rate possibilities can vary by as much as .75% or more depending upon how much equity there is in the transaction. For instance, if your credit score is 780 your interest rate might be 3.50% with a 20% down payment whereas with that same 20% down and a credit score of 685 your rate would be closer to 3.875% to 4.00%.

Early on, credit scores were less of a determining factor when getting a mortgage. Mortgage rates were not based upon a particular number as long as the loan received an approval. You can still get a mortgage with a lower credit score but it is much more difficult than in the past. In addition, the borrower’s credit history will be reviewed mainly looking for bankruptcies, judgments, short sales, foreclosures (deed in lieu of or full), plus timely payments of rent and/or mortgage payments, in detail for the previous 2 years and up to 7 years of repayment history. A payment is considered late if more than 30 days past due. Exceptions may be made for justifiable reasons.

Within the past few years risk based pricing has developed. Risk based pricing is simply a method of layering the lenders risk of default and meeting the eligibility requirements of the secondary market. This helps the mortgage lender manage and evaluate its risk on a loan-by-loan basis. All lenders apply this very same risk based pricing matrix program from coast to coast. Lenders utilize the program to evaluate the amount of equity or down payment required in relation to the credit score. This helps determine interest rate options. It applies to both conventional loans as well as government insured mortgages such as VA, FHA and USDA loans. Manual reviews are not totally gone. An underwriter still has the responsibility to verify aspects of the file once the program has approved the loan. They can deny the approval if need be. In addition to the risk based pricing matrix certain lenders may apply their own internal risk-based credit guidelines. Typically these additional guidelines only apply to circumstances such as a refinance where the borrower pulls out cash, nonconforming loans, investment property, and/or portfolio lending.

There are so many myths surrounding credit scores that many times potential homeowners don’t even bother applying for a mortgage. You can get a mortgage with a low credit score as long as you meet the minimum requirements. Credit scores do in fact impact your interest rate but the overall impact is less than one might think. If anyone has questions about whether or not they qualify, what they need for a down payment, or what their monthly payment would be, the best thing to do is to have them get a pre-approval. Note: There is a difference between a pre-qualification and a pre-approval. A pre-qualification is simply an assessment of what information the buyer has provided where a pre-approval is an analysis of the information in conjunction with a current credit report before employment and other verifications. Thus a pre-approval more closely resembles what an underwriter will receive and is a lot better indication of the borrower’s financing capability.

FHA INSURED LOANSFHA insures against losses on real estate loans made by private lending institutions. Since its inception, FHA has enlarged and expanded its scope of operations to include rent programs, interest subsidy programs, and a myriad of other mortgage lending activities that have a special social emphasis. A FHA loan is a viable product for first-time home buyers or borrowers with credit issues who may have trouble qualifying for a conventional loan and/or need a lower down payment.

FHA is a program of mortgage insurance so it does not make direct loans to borrowers. Any lender participating in the FHA insurance program must grant long-term, self-amortizing loans at interest rates established in the marketplace. There is no limit on the fees that may be charged to the borrower, although they must be reasonable. FHA designates qualified lenders to underwrite loans directly, without submitting applications to the FHA, participating in a direct endorsement program. Every FHA loan application is reviewed carefully to determine the borrower’s financial credit and ability to make payments. In addition, a comprehensive written appraisal report is made on the condition and value of the property. The FHA will then issue a conditional commitment for mortgage insurance to the lender reflecting the value of the property. This commitment is valid for six months on existing properties and for nine months on new construction.

Insuring 100 percent of the loan amount eliminates lenders’ risks. This preserves their fiduciary profiles by ensuring that FHA lenders will not lose any money on loans they make to eligible borrowers. The insurance helps stabilize the mortgage market and develops an active national secondary market for FHA loans. By designing programs of mortgage insurance FHA also reduces the down payment obstacle for cash-short buyers. FHA insured programs include:

• Section 203(b) Mortgage Insurance for One-Family to Four-Family Homes: The mainstay of the FHA single-family

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insurance programs remains an important financing option for first-time home buyers, persons who may have trouble qualifying for a conventional loan, or those living in under served areas. The low down payment, higher debt ratio’s, and consideration of compensating factors may make it possible for owner-occupants to achieve home ownership.

• Section 203(k) Rehabilitation Mortgage Insurance: This makes it possible for the purchaser to obtain a single long-term loan (either fixed or adjustable rate) to cover both the acquisition and rehabilitation of a property. The 203(k) is also available for refinancing a property that is at least one year old. The value of the property is limited by the FHA mortgage loan limits for the area and is determined by either the value before rehabilitation plus the cost of rehabilitation or 110 percent of the appraised value after rehabilitation, whichever is less. Other features include; Rehab costs must be at least $5,000; Prospective buyers can add $5,000 to $15,000 to the loan amount for renovations to meet FHA minimum standards; The borrower pays only taxes and insurance during the first six months; The rehab funds are paid to the borrower in draws; The rehab costs and installation time must be approved by the lender before the loan can be granted; The loan is made at 97 percent LTV (3 percent down); Basic energy efficiency and structural standards must be met; The program is not available to investors.

• Section 234(c) Mortgage Insurance for Condominium Units: This is specifically for the purchase of a unit in a condominium building of at least four dwelling units. It can be detached, semi-detached, row house, walk-up, or elevator structure.

• Section 251 Insurance for Adjustable Rate Mortgages: FHA adjustable-rates mortgages are available to owner-occupants of one to four-family dwelling units. The down payment, maximum loan amount, and qualifying standards are the same as for 203(b) and may be written for 30 years. Hybrid five-year adjustable-rate loans that carry popular 2% annual rate-increase limits and 6 percent life-of-the-loan limits are available with a 3 percent down payment.

• Section 202 Supportive Housing for the Elderly: This provides capital to private nonprofit organizations for the construction, rehabilitation, or acquisition of supportive housing for low-income elderly persons.

• Section 811 Supportive Housing for Persons with Disabilities: This provides direct funding to nonprofit organizations to support housing for low-income adults with disabilities.

• Section 203(h): Mortgage Insurance for Disaster Victims.• Section 203(i): Mortgage Insurance for Homes in Outlying Areas.• Section 203(n): Single-Family Cooperative Mortgage Insurance.• Section 221(d)(2): Mortgage Insurance for Low and Moderate Income Buyers.• Section 222: Mortgage Insurance for Members of the Armed Services.• Section 223(e): Mortgage Insurance for Older, Declining Areas.• Section 237: Mortgage Insurance for Persons with Credit Problems.• Section 245: Graduated Payment Mortgage Insurance.• Section 245(a): Growing Equity Mortgage Insurance.• Streamline Refinance: FHA permits insured mortgages to be streamline refinanced. The amount of documentation

and underwriting is greatly reduced, although closing costs will still apply. These costs can be included in the new mortgage amount with sufficient equity in the property as determined by an appraisal. The basic requirements include; the mortgage must already be FHA insured; The mortgage must be current, not delinquent; The refinance must result in lowering of monthly principal and interest payment; No cash may be taken out.

Additional Special Programs through the Department of Housing and Development (HUD) include:• Energy Efficient Mortgage: This can be used to finance the cost of adding energy-efficient features to new or existing

homes in conjunction with a Section 203(b) or 203(k) loan. It can also be used with the Section 203(h) program for victims of presidential-declared disasters.

• Home Equity Conversion Mortgage: FHA’s mortgage insurance makes this reverse mortgage program less expensive and more attractive for homeowners 62 and older who wish to borrow against the equity in their home. No monthly payments are required. There is no asset, income requirements, or limitations. Homeowners may receive a percentage of the value of the equity in the home in a lump sum, on a monthly basis (either for life or for a fixed term), or as a line-of-credit. No repayment of the loan or interest and other fees is due until the surviving homeowner leaves the home. The FHA insurance provides assurance that the funds will continue as long as one surviving member remains in the home. In the event the eventual sale does not cover the balance due the lender there will be no debt carried over to the estate or heirs.

• Officer Next Door: This program for full-time law enforcement officers allows them to purchase properties located in Revitalization Areas. An officer may purchase the property with a down payment of $100 and may finance all closing costs. If the property needs repairs a 203(k) mortgage may be used.

• Teacher Next Door: Any full-time state-certified teacher or administrator in grades K-12 is eligible for this program which is handled in the same manner as the Officer Next Door program.

• Home Ownership Vouchers: The Housing Choice Voucher program, formerly known as Section 8, expanded its rental

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assistance program to allow participants to use home ownership voucher funds to assist in meeting monthly home ownership expenses such as mortgage payments, real estate taxes, insurance, utilities, maintenance and repairs. Applicants must be first-time homeowners, at least one member of the family employed, and meet minimum income requirements.

• Native American Housing: Home ownership and housing rehabilitation opportunities for Native American individuals, families, and tribes.

FHA LENDING GUIDELINES

FHA has its own set of guidelines to qualify eligible borrowers for loans. The requirements include:• Maximum Loan Limitations: These limits vary by geographic area and are adjusted each October as a percentage

of the Fannie Mae and Freddie Mac conforming loan limits. Maximum FHA loan limits are set at 95% of the median house price for metropolitan statistical areas up to various limits.

• Down Payment Requirements: The purchaser must provide 3.5% of the sales price to be used for the down payment and/or closing costs. These funds may be the purchaser’s own money, family member gifts, or grants from local, state, or nonprofit down payment assistance programs. Currently the seller may contribute up to 6% of the sales price to be used for discount points, prepaid expenses, and other allowable closing costs.

• Borrowers’ Income Qualifications: Borrowers must qualify based on two ratios: the housing debt ratio (PITI) which may not exceed 29% of total gross monthly income. This will include homeowners or condominium association fees if applicable. The housing ratio may be raised if the borrowers have certain compensating factors, such as: low long-term debt; large down payment; minimal credit use; excellent job history; excellent payment history for amounts equal to or higher than new loan payment; or additional income potential. The total debt ratio may not exceed 41% of the total monthly gross income. Alimony and child support payments are deducted from monthly gross income before calculating these. For borrowers who qualify for an Energy Efficient Mortgage the ratios may be stretched to 33% for housing debt and 45% for total debt.

• Allowable Closing Costs: FHA has strict guidelines defining allowable closing costs that may be charged. The amounts differ by geographic area but must be considered reasonable and customary. Allowable closing costs include: appraisal fee; inspection fees; actual costs of credit reports; lender’s origination fee; discount points; deposit verification fee; home inspection service fees; cost of title examination; title insurance; document preparation (by a third party not controlled by the lender); property survey; attorney’s fees; recording fees, transfer stamps and taxes; test and certification fees; water tests. In the case of a refinance all other costs in the transaction are generally paid by the seller or lender.

• Mortgage Insurance Premium: When the FHA issues an insurance commitment to a lender, it promises to repay the balance of the loan in full if the borrower defaults. This is funded by imposing a mortgage insurance premium (MIP) cost paid by the borrower. It can be paid upfront in cash or financed.

• Second Mortgages: FHA allows a second mortgage on the property. There are certain conditions; The total of the first and second mortgages must not exceed the allowable maximum LTV ratio; The borrower must qualify to make both payments; There can be no balloon payment on the second mortgage if it matures before five years; The payments on the second mortgage must not vary to any large degree; The second mortgage must not contain a prepayment penalty.

• Buydowns: FHA allows mortgage buydowns. This is when the borrower or seller make an advance cash payment to lower the interest rate. FHA also allows the borrower to qualify for the loan at the bought-down interest rate.

• Assumptions: FHA allows assumptions. The new buyers have to qualify and occupy the property. FHA prohibits the loan assumptions by investors. Additionally, the sellers (original borrowers) may not be released from liability under an assumption. This will be determined by the lender.

• Prepayment Penalty: FHA does not allow prepayment penalties. The absence of a prepayment penalty allows the borrower to increase the monthly payment or prepay the loan.

VA GUARANTEED LOANSSpecial finance programs have been established to provide funds to eligible veterans, reservists, and members of the National Guard to enable them to purchase homes, farms, or ranches, and to improve these properties. The VA guarantees loans and eliminates risks made by primary mortgage lenders for eligible veterans. If a veteran cannot continue to meet the required payments the lender is compensated by the VA for any losses incurred in the foreclosure and sale of the property up to the guarantee limit.

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In the past, the VA specified the interest rate the lender could charge the veteran. Now, however, the VA allows the borrower the opportunity to shop the marketplace for the best rate. Each loan application is reviewed carefully to determine the veteran’s eligibility, credit history, and ability to pay. The value of the property is established by a VA certified appraisal. The veteran will occupy the premises as their principal residence. Several veterans related or not, may purchase one-family to four-family homes as partners, as long as they intend to occupy the property. A veteran and a non-veteran who are not married may purchase a home together as co-borrowers, although the VA will not guarantee the non-veteran’s portion of the loan. However, the VA does qualify common-law marriages without reduction of the loan guarantee for the non-veteran, as long as proper documentation has been supplied. Un-remarried spouses of veterans may be eligible for VA loans if the veteran died of a service related injury or illness, or is listed as missing in action.

VA LENDING GUIDELINES

The VA has its own set of guidelines to qualify eligible borrowers for loans. The requirements include:• Certificate of Eligibility: This certificate, which the veteran gets based on service, determines loan guarantee

entitlement (maximum loan amount the VA will guarantee with no money down). There is no time limit on the entitlement, it remains in effect until completely used up, and can only be used in the U.S., its territories, and its protectorates. After using the VA guarantee for a real estate loan, the veteran may gain the restoration of eligibility by selling the property and repaying the debt in full. Veterans who have used their benefits in the past may be eligible for another VA loan if they have any remaining entitlement. With a partial entitlement, a veteran may pay cash down to the maximum loan amount. A recent change allows for a one-time only restoration of entitlement with repayment of the debt without having to sell the property. A veteran can get a restoration of entitlement if the home is sold to another qualified veteran willing to assume the loan.

• Certificate of Reasonable Value (CRV): Required VA appraisal prepared by a VA certified appraiser. The CRV is valid for 6 months for existing properties, 12 months for new construction. If the sale is made subject to the CRV and it comes in at less than the sale price, any of the following may occur; The buyer can make up the difference in cash (the VA reserves the right to approve the source to ensure that they are not borrowing an amount that would adversely affect the total debt ratio); The seller can accept the lower amount as the sale price; The buyer and the seller can compromise; or The transaction can be canceled.

• Income Qualifications: The VA utilizes only one ratio to analyze a borrower’s ability to qualify for the loan. The total debt ratio. It is 41% of borrower’s gross monthly income. It includes PITI, utilities, maintenance, repairs and other monthly obligations. The VA publishes information for maintenance, repair, and utility estimates for various regions in the U.S. based on a property’s square footage, age, and whether the property has a pool, air-conditioning, or evaporative cooling (e.g. a regional office could allocate $76 per month for maintenance and repairs to a house more than three years old, consisting of 1,600 square feet, including a pool and air-conditioning, and $214 per month for the utilities). The VA does have a second way to qualify potential borrowers called residual qualifying. They publish tables of monthly income amounts defined by family size and region in which they live for this.

• Allowable Closing Costs: These must be paid at closing. The only costs that may be charged to the veteran include; 1% loan origination fee; Discount points as determined by the market; VA funding fee, which may be paid cash or included in the loan amount, even in excess of the CRV (the addition of the funding fee to the loan amount may not exceed the maximum allowable loan); Reasonable and customary charges for appraisal, credit report, recording fees, taxes and/or assessments hchargeable to borrower, initial deposit of tax and insurance escrow account, hazard insurance including flood insurance, survey if required, title examination, and title insurance. The seller may pay all of the borrower’s closing costs plus an additional 4 percent of the loan amount to be used for the funding fee or to pay off other debt to qualify for the loan.

• Second Mortgages: They are allowed under the following conditions; The second mortgage document must be approved by the VA legal department prior to loan closing; The total of the first and second mortgages liens may not exceed the value of the property; The second mortgage may not have a prepayment penalty or a balloon payment; The second mortgage must be amortized for at least five years.

• Buydowns: They are only allowed on VA loans issued with level payments. The buydown fee can be paid by the seller, the buyer, or family members. The borrower must qualify at the first year’s payment rate.

• Assumptions: VA loans are assumable by a veteran or non-veteran. The buyer’s credit must be approved by the lender prior to the assumption of an existing loan. Any unauthorized assumption may trigger a technical default and the loan balance can be called in full. Assumption of a VA loan by a veteran will release the original veteran from liability and restore entitlement. If a veteran’s loan is assumed by a purchaser who is not a veteran, the VA will not allow the veteran to regain maximum entitlement. The purchaser, however, can agree to assume the veteran’s liability to reimburse the VA in case of default. The buyer and veteran can then petition the VA to release the veteran from all obligations. The release of a veteran’s liability does not restore eligibility for the maximum

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guarantee amount. It will not be restored until the loan is finally paid off. • Additional Programs: The VA guarantees loans for condominiums, cooperatives, manufactured housing, and

mobile homes. Three types of refinance programs are available to veterans; Streamline Interest Rate Reduction Refinancing Loan (refinance for a lower interest rate with no out-of-pocket costs, no appraisal required, and no income or credit check); Cash Out Refinance (refinance using existing equity to take out cash or pay off debts up to 90 percent of the value of the property); Conventional to VA Mortgage (refinance from a conventional loan to a VA loan).

DEFAULTA default is the breach of one or more of the conditions or terms of a loan agreement. When a default occurs, the acceleration clause contained in the mortgage is activated, allowing the lender to declare the full amount of the debt immediately due and payable. If the borrower cannot or will not meet this requirement, lenders can foreclose. While any default in a loan enables the lender to accelerate the debt, most lenders seek to avoid foreclosure by arranging a plan with the borrower. This will try to protect the interests of both parties and avoid costly time-consuming court procedures. These efforts are called workouts and take the form of payment waivers, refinancing, etc. However, in irreconcilable situations foreclosure is inevitable.

Most loan defaults occur when the borrower falls behind in making payments, paying taxes, or insurance premiums. Loan agreements stipulate that the regular payment is due “on or before” a specified date, but most lenders will allow a reasonable grace period, usually up to 15 days, in which to receive the regular payment. Many loan arrangements include a late payment charge of a specific amount that is to paid by the borrower if they exceed the grace period. This late payment fee is imposed to encourage promptness and offset the extra costs that delinquent accounts entail. Most lenders are not disturbed by payments made within grace periods, but will take remedial action when a borrower consistently incurs late charges or exceeds the delinquency period. There is also a provision in the mortgage that requires a borrower to not waste the property (maintain it in such a manner that its value will not diminish to the point of undermining the lender’s security position). A breach of this also creates a default.

A final foreclosure action is avoided whenever possible. There is no preset or determined amount of time from default to when the foreclosure process will start. It is determined by the lender. Before they decide to foreclose, consideration is taken of the amount of the borrower’s equity in the property, the general state of the current real estate market, and the positions of any junior lien holders. The lender also judiciously weighs the circumstances that caused the default and the attitude of the borrower concerning fixing the breach. The time a foreclosure is considered is when the current market value of the collateral property is less than the total balance of the indebtedness and the borrower can no longer make the payment.

The greatest risk to a lender making a real estate loan is that a property will be abandoned by the borrower. Although this risk is considerably less for unimproved land, any improved property left vacant becomes an immediate and irritating source of concern for a lender. Borrower frustration may cause them to blindly seek retaliation and perhaps even physically damage the property. Even if an abandoned property is left in good condition, a vacant building is often an invitation for vandalism or for the stripping of any valuable parts.

SHORT SALE

A short sale is the sale of the property in which the proceeds do not amount to the full indebtedness of the outstanding liens. In other words, there is not enough money from the sale to pay all the debts. In these cases there are two ways a borrower may be able to clear the title liens and transfer the property. Either, the borrower comes up with the balance owed or the lender/lenders reduce the amount owed and release the lien to allow the transfer of the property.

Most loans are recourse loans (if the lender does not receive the full amount owed from the sale of the property then they can go after the borrowers personally for the balance owed). If a lender receives less money than the entire loan balance, interest to date, and costs incurred when the sale has been completed, the lender may pursue the borrower for those losses by seeking a judgment for the deficiency. Given this the lenders are in control of whom they allow to do a short sale and whether or not to seek a deficiency judgment. The lenders are aware that allowing a short sale is less costly than foreclosure, so for the borrowers who cannot afford the property and are headed to foreclosure regardless, the lenders may try to work with them.

Short sales happen before or during the foreclosure process as a lender will not discuss a short sale unless the borrower

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is in default. This is the reality of a short sale so what should you do. First, discussion need with the lender need to determine what the lender will accept and if they will seek a deficiency judgment. The lender is not a party to the contract but their approval is like a contingency. If they are not willing to give it then the sale cannot be consummated. If the loan has PMI (private mortgage insurance) the lender will be less likely to work with the borrower because if they foreclosure they can collect on that insurance. If the lender will work with the borrower then they need to get a contract for the sale of the property and final lender approval.

DEED IN LIEU OF FORECLOSURE

When all efforts to solve the borrower’s problems have failed, a lender may seek to secure a voluntary transfer of deed from the borrower. A deed in lieu of foreclosure is a mutual agreement in which the delinquent owners of a property, deed it to the lender in return for various considerations, usually a release from liability under the terms of the loan and avoidance of a deficiency judgment. It can be completed quickly but the rights of the junior lien holders are left undisturbed, so the borrower may still be liable for the liens not cleared prior to the transfer.

FHA AND VA

FHA requires that lenders provide relief in situations in which default is beyond a borrower’s control (e.g. a lender might extend the mortgage of a borrower who has defaulted because of unemployment during serious illness). The VA also requires leniency in the case of a borrower who is willing, but unable, to pay. The VA itself may pay for such delinquencies in order to keep a loan current for a veteran, although these payments do not reduce the veterans obligation. The VA retains the right to collect these advances at a future date.

FORECLOSUREWhen all else fails a lender pursues foreclosure to recover the collateral in order to sell it and recoup their investment. Foreclosure is not only a process to recover a lender’s collateral but also a procedure whereby the borrower’s rights are eliminated and all their interests in the property are removed. A common foreclosure procedure is a Judicial Foreclosure and Sale. It involves the use of the courts and the subsequent sale at public auction. Illinois requires judicial foreclosures. The basic steps and borrowers rights in Illinois are:

1. The lender files a foreclosure action with the county court in which the property is located They receive and serve the borrower with a summons (notice) of default. Additionally, the notice is published in a local periodical. Simultaneous with this a title search is made to determine the identities of all parties having an interest in the collateral property. Notice is sent to all parties having an interest in the property, requesting that they appear to defend their interests, or else they will be foreclosed from any future rights by judgment of the court. It is important for the complainant-lender to notify all junior lien holders of the foreclosure action lest they be omitted from participation in the property auction and thus acquire the right to file suit on their own at some future time. Additionally, a Lis Pendens is filed with the court and recorded in the public records giving notice to the world of the pending legal action.

2. The borrower then has a 90 day statutory right of reinstatement from the date of service of summons or publication date, whichever is later, to cure the default and reinstate the loan as if no default had occurred. This only requires they pay the missed payments, interest and costs incurred and not the entire loan amount.

3. Simultaneously the borrower’s equitable right of redemption (7 months from the date of service of summons or publication date whichever is later) is activated (this can be shortened to as little as 30 days for a property that is vacant or abandoned). This is the last opportunity for the borrower to pay off the liens and retain control of the property. This requires payment in full of the entire loan balance, interest to date, and costs incurred.

4. At the end of the equitable right of redemption the lender will petition the court for the foreclosure sale to held. In most instances the borrower does not appear in court unless special circumstances are presented in defense of the default. Those creditors who do appear to present their claims, are recognized and noted, and a sale of the property at public auction by a court-appointed referee or sheriff is ordered by means of a judgment decree. The entry of a decree will lead to what is commonly known as a sheriff’s sale. At the sheriff’s sale the borrower losses all rights in the property except possession. Possession will have to be given up 31 days after confirmation of the sale and they may be required to pay rent to the successful bidder of the sale. Upon confirmation of the sale a sheriff’s deed is issued.

A public sale is necessary in order to establish the actual market value of the property. The first mortgagee usually makes the opening bid. The bid is an amount equal to the loan balance plus interest to date and court costs. The lender then hopes

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that someone else will bid at least one dollar more to pay them off. If there are any junior lien holders or other creditors they now have an opportunity to bid. Their bids obligate them to repay the first mortgage loan. If no junior lien holders or creditors enter a bid, the auction closes. The first mortgagee does not need to pay themselves and now they will receive legal title. Any interests that junior lien holders may have in the property are effectively eliminated. If any other person bids an amount above the first mortgage, after the first lien is paid, the excess funds are distributed to the junior lien holders in order of priority with any money left over going to the defaulted borrower.

FHA-INSURED MORTGAGES

Foreclosures on FHA-insured mortgages originate with the filing of a Notice of Default, which must be given to the local FHA administrative office within 60 days of default. This notice describes the reasons for the borrower’s delinquency, such as death, illness, marital difficulties, income depletion, excessive obligations, employment transfers, or military service. In many cases counselors from the local FHA offices will attempt to design an agreement between the lender and the borrower for adjustments to the loan conditions in order to prevent foreclosure.

If the problems causing the default are solved within a one-year period, the lender informs the local FHA office of the solution. If not, a default status report is filed, and the lender must initiate foreclosure proceedings. If the bids at the auction are less than the unpaid balance, the lender is expected to bid the debt, take title, and present it to FHA along with a claim for insurance, which may be paid in cash or government debentures. In some cases, with prior FHA approval, the lender may assign the defaulted mortgage directly to FHA before the final foreclosure action in exchange for insurance benefits. If FHA ends up as the owner of the property, the collateral will be resold as is, or repaired, refurbished, and resold at a higher price to help minimize losses.

VA-GUARANTEED MORTGAGES

Much like FHA, VA lenders are required to make every effort to offset a foreclosure through forbearance, payment adjustments, sale of the property, deed in lieu of foreclosure, or other acceptable solutions. In the event of a delinquency of more than three months on a VA loan, the lender must file proper notification, which the VA may then elect to bring the loan current if it wishes. In the event of a foreclosure, the lender is usually the original bidder at the auction. If there are no other bids they will take title and submit a claim for losses to the local VA office. The VA then has the option either to pay and take title to the collateral, or to require that the lender retain the property and the VA will pay the difference between the determined value of the property and the total costs.

TAx IMPACTS

In a foreclosure, there may be unexpected tax consequences for the person or entity that has borrowed the money. Normally, paying off a real estate loan has no tax consequences. When the last payment is made, all principal borrowed has been returned. However, in a foreclosure or short sale the loan can be retired without being paid in full. According to the IRS this is considered income. Tax is due when the property’s value is less than the balance of the loan. The amount of the defaulted loan forgiven is considered a gain. This applies to both foreclosures and short sales.

DefICIenCy JuDgmentsAs mentioned earlier most loans are recourse loans. If a lender receives less money than the entire loan balance, interest to date, and costs incurred after the delinquency, default, and the short sale or foreclosure process have been completed, the lender may pursue the borrower for these losses. The lender sues in court, secures a judgment for the deficiency, the right to a general lien against the defaulted borrower, that may be placed on any real or personal property currently owned or acquired in the future by the borrower.

No deficiency judgments are allowed by the FHA. It is possible to obtain a deficiency judgment under a VA guaranteed loan but the VA frowns on this practice. Many commercial real estate loans are Non-Recourse Loans (loans which limit a borrower’s liability to the equity in the property) so the lender is not able to seek a deficiency judgment.

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CREDIT IMPACTOnce a person has gone through a short sale, deed in lieu of, or full foreclosure, they will need a certain amount of time to establish credit again to be able to get financing for real property. Also, lenders in the primary mortgage market, purchasers in the secondary mortgage market, plus FHA and VA require any judgments to be released before making a new mortgage loan. Certain exceptions may apply in non-conforming and portfolio lending provided it does not affect title.

Currently, Fannie and Freddie with less than 10 % down require 7 years, 10 to 20% down 4 years, and 20% or more down 2 years to have passed to be considered for a mortgage loan after a short sale or deed in lieu of foreclosure. FHA is 3 years but with extenuating circumstances this could be as short as 1 year. Full foreclosure is 7 years no matter the down payment.

APPRAISAL INTRODUCTIONAn appraisal is an estimate of value based on supportable data. It is only as good as the reliability of the data and techniques used plus the accuracy, skill, judgment, experience, and expertise of the person preparing it. When preparing an appraisal three basic approaches to value are used: the Sales Comparison Approach, the Cost Approach, and the Income Approach. Each method addresses the property from a different perspective. An appraiser is required to use all three approaches in every appraisal unless they can justify one of the approaches does not add to the quality of the appraisal.

In most real estate transactions appraisals are required by lenders. The value derived will determine the amount of money the lender is willing to lend. The loan amount relative to value is based off of the sale price or the appraised value whichever is lower. While real estate agents do CMA’s to determine a marketable value, a CMA is only a fraction of the data, information and steps that an appraiser will go through in an appraisal. Understanding appraisal concepts and steps can help real estate agents develop more accurate CMA’s.

The opinion of value estimated by the appraisal is known as Market Value or Fair Market Value. Market Value is the most probable price a buyer is willing to pay a seller for their property in the open market in an arms length transaction. The selling price of a property is known as Market Price. Market Value is an estimate of Market Price. The Market Value is not and may not be the same as Market Price. Determining Market Value can also be different from determining an asking or offering price for the property. Essential to the definition of Market Value are these factors:

• Most probable price, may not always be the highest price.• Buyer and seller are unrelated.• Neither buyer or seller are acting under duress.• Both buyer and seller are knowledgeable about the property’s use, potential, defects, and advantages.• A reasonable length of time to market the property has been obtained.• Normal consideration is made for payment without any special financing or other concessions.

REAL PROPERTY

When determining a market value we need to understand some basic definitions:1. LAND: The surface, subsurface (extending to the center of the earth), and air rights (extending upward to

infinity). This includes permanent natural objects.2. REAL ESTATE is the land plus all improvements and additions permanently attached to the land.3. REAL PROPERTY is the land and real estate plus the legal interests, benefits, and rights included in the

ownership of real property. These are commonly known as the bundle of legal rights which include: right of possession; right of control; right of enjoyment; right of exclusion; and, right of disposition.

Many times real estate licensees will refer to what they are working with as real estate, when in fact it is real property. The importance of this becomes clear when looking at value. Legal rights can enhance or limit our use of the property (e.g. encumbrances such as deed restrictions, restrictive covenants and associations, easements, liens, encroachments, etc.) thus having a positive or negative affect on value. It can be substantial.

The key public effects on value are taxation and police powers. As property taxes increase, they have a negative effect on an individual’s ability to qualify for financing thus reducing demand and keeping values lower. Police powers are the rights given to the local municipalities by the state and federal governments through enabling acts to regulate real

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estate at the local level for the health, safety, and welfare of the general public. Those that affect value include zoning ordinances, building codes, land and subdivision regulations, traffic flow and regulations, water rights and restrictions, plus various other required permits needed for the use or improvement of real property.

Additionally, when valuing real property we need to be aware that personal property should not included. Personal property is property that is not attached by some type of permanence or not part of an improvement that is real property (e.g. window screens. While not attached they are part of the window which is real property). An appraisal determines market value for real property. So should a CMA. Personal property such as a stove, refrigerator, washer, dryer, etc. should not included in the estimate of value.

PRINCIPLES OF VALUEThese are the key concepts to be evaluated when estimating value. They help justify, explain, and understand value. They can also give insight into where the future value of the property may be headed.

HIGHEST AND BEST USE

This should always be the first thing evaluated. Highest and best use is the property achieving it greatest value when used in the most profitable or maximally productive way that is legally permitted, economically/financially feasible, and physically possible. It is the most profitable single use to which a property may be put. If there is a higher and better use that would create greater value, then the estimate of value should be based on that use. In most cases properties are being used as highest and best. Examples of properties not being utilized to their highest and best use would include a residential property on a major street that would be better suited for commercial, or an old industrial building that may be suited for residential lofts or torn down for commercial development.

ECONOMIC AND PHYSICAL CHARACTERISTICS

The economic characteristics of real property include improvements, investment, location, and scarcity. How the property is improved and what the improvements are has a profound impact on value. So does the location and scarcity of the property. You cannot change location and there is only so much land available in any given area.

The physical characteristics of real property include immobility, indestructibility, and uniqueness. You cannot move land, there is a limit to the amount in any given area and no more can be added. Land is indestructible. It can change dramatically (e.g. open pit mine) or quickly (e.g. earthquake or landslide) but it always exists. Every property is unique. Whether it is the location relative to it surroundings, public access, water, etc., this uniqueness will have an affect on value even when dealing with seemingly identical properties in the same area.

SUPPLY, DEMAND AND COMPETITION

Supply, demand, and competition have a direct correlation on value. The value of any property is influenced by the number of buyers relative to the number of sellers. Supply is influenced by government controls, government financial policies (interest rates), and construction costs. Demand is influenced by population, demographics, employment, and wage levels. Financing requirements, availability, and general overall economic conditions also play a key role.

Competition is the interaction of supply and demand. If, in an area, values rise dramatically, then other sellers may emerge or new construction will develop to increase supply. Evaluating whether it is a sellers market (more buyers than available properties), or a buyers’ market (more sellers than buyers), or if the market is in equilibrium (a balance between buyers and sellers) determines this interaction. This has direct affect on whether values will go up, down, or stay relatively stable. Simply put, prices follow demand. So in times of greater buyer demand prices will rise. When buyer demand decreases so do prices. From a value standpoint this is not an easy concept to justify in real time. It becomes clearer in the future as property sales are closed and the comparisons made.

CONFORMITY, PROGRESSION AND REGRESSION

Conformity implies that the maximum value is created when a property is in harmony with its surroundings. Maximum

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value is realized if the use of property conforms to the existing neighborhood standards. When there is lack of conformity (e.g. a residence on a major street, next to a shopping center or industrial park, etc.) the value will be decreased. Coinciding with conformity is progression and regression. Progression is the concept that the smaller or poorly maintained properties in a neighborhood will increase in value due to the surrounding larger or better maintained properties. Regression is where the largest or best maintained properties in the neighborhood will decrease in value due to the surrounding smaller or poorly maintained properties.

CONTRIBUTION, INCREASING AND DIMINISHING RETURNS

Improvements on the property contribute to the value of the whole. As improvements are added, subtracted, deteriorate, or redone, they positively or negatively contribute. The time period that an improvement will contribute to value is considered it’s economic life. Once an improvement has reached the end of it’s economic life it no longer contributes to value so it should be removed or replaced. When considering whether an improvement or part of an improvement should be added or replaced, the principles of increasing and diminishing returns are considered. The addition or replacing of improvements increases total value only to a certain amount. Beyond that point, additional expenditures will not increase the property’s value. Increasing returns is when an expenditure will increase the value of the property beyond the amount invested. Diminishing returns is where the value does not increase as much as the amount invested. Improvements should be added or replaced when they provide increasing returns. Thus, delay or forgo improvements that provide diminishing returns.

ANTICIPATION

Anticipation is the expectation that value will increase or decrease because of some future benefit, detriment, or event will occur. This is why most people buy real property (e.g. it will be worth more tomorrow than today).

GROWTH, EQUILIBRIUM, DECLINE AND REVITALIZATION

Individual properties as well as neighborhoods undergo change. The effects of ordinary physical deterioration and market demand dictate that property will pass through four stages:

1. Growth: properties are being built and improved; neighborhood demand is rising.2. Equilibrium: properties appear to undergo little change; neighborhood is stable.3. Decline: properties require increasing amounts of upkeep; neighborhood not in demand.4. Revitalization: properties and neighborhoods become attractive for gentrification and begin again with growth.

3 APPROACHES TO VALUESALES COMPARISON APPROACH

The sales comparison approach, also known as the market data approach, is similar to a CMA. It is the concept that a properties market value can be estimated by comparable properties market prices. It takes current comparable property market prices, adjusts for differences between the comparable properties and the subject property (property being appraised) to come up with a market value of the subject property. This approach to value is best suited for properties with plenty of available, usable comparable sales (e.g. residential properties).

Substitution is the foundation of the sales comparison approach. The value of a property tends to be set by how much it would cost to purchase an equally desirable substitute property. The rationale is that a knowledgeable buyer will pay an equivalent price for the subject property as other buyers have paid for comparable properties. To come up with the estimated value the appraiser will find three to five similar properties and make positive or negative adjustments.

Because no two properties are exactly alike each comparable property needs to be analyzed for differences and adjustments made. The most difficult step in the sales comparison approach is determining the dollar amount of the adjustment. When looking for comparable properties appraisers try to find those that need minimal adjustment. The fewer adjustments to be made the more accurate the appraisal. Elements for comparison and adjustment include:

• Property Rights: Fee simple or less than fee simple, plus adjustments made for any public or private restrictions.• Sales or Financing Concessions: Adjustments made for cash, traditional, or owner financing, including any credits

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or kickbacks. This can include factors such as foreclosure, a short sale, a sale between family members, etc.• Date of Sale: Adjustments made for time lapsed since the comparable sale with respect to change in market

conditions (interest rates, supply and demand, appreciation, or other economic factors). When appraising it is best to keep the comparable sale dates as close to the date of the appraisal as possible to minimize adjustments.

• Location: Adjustments made for differences of a comparable in the same area or different areas.• Age: Adjustments for a difference in the age of a comparable.• Site: Land adjustments for size, shape, location, topography, landscaping, improvements, etc. • Physical Features: This will include all the different details of the improvements such as construction, style,

number of rooms, bedrooms, baths, square feet, basement, condition, etc.

Adjustments are made to the comparable properties. They have a price that can be adjusted where the subject property does not have a value yet. We start with the market price of the comparable. If the comparable has a better amenity than the subject property, we reduce the comparable property price to accommodate for the subject properties lack of that amenity. The adjusted price will then more closely reflect the market value of the subject property. Thus, the opposite is true. If the comparable lacks an amenity that the subject property has then the comparable property price will be adjusted upward to include value for the amenity that the subject property has.

After the adjustments are made to each comparable then the adjusted prices of all the comparable properties are reconciled to come up with a market value of the subject property. Reconciling is not averaging. It is evaluating the data to establish the best estimate of value for the subject property. Since all adjustments are subjective, the comparable properties with the least adjustments may provide the most reliable and best estimate of value.

COST APPROACH

The cost approach estimates the market value of the property by determining the value to construct the improvements in their current condition, plus the land value. The land value is calculated separately as land is indestructible and does not depreciate. You start by determining the reproduction or replacement cost of the improvements as new. The reproduction cost (exact duplicate using the same construction methods and materials) or replacement cost (using similar/comparable construction methods and materials) is determined in one of four ways:

• Square-foot method: Uses the current dollar per square foot cost for the type of construction.• Unit-in-place method: The summation of value of the components.• Quantity-survey method: Calculation of every cost involved in construction of the improvements.• Index method: Applies a factor representing the change in building costs since the original construction.

After determining the reproduction or replacement cost as new, an appraiser will subtract the loss in value from all sources. This is known as depreciation. Depreciation is the loss in value from when it was new or original to its current condition. Depreciation can be curable or incurable. The difference between them is whether it is economically feasible to replace an item, component, or improvement. The law of increasing or diminishing returns. If the replacement will provide increasing returns, than the existing item, component, or improvement has reached the end of its economic life, is no longer contributing to value, and should be replaced. This is known as curable. If it is diminishing returns, where the cost will not justify an increase in value, then the item, component, or improvement is still contributing to value and does not need to be replaced at this time. This is known as incurable. There are three types of depreciation:

• Physical Deterioration: Curable or Incurable; loss in value from wear and tear, deterioration, material and/or latent defects, etc.

• Functional Obsolescence: Curable or Incurable; loss in value from deficiencies in the property such as poor layout or design, or inadequate mechanical systems.

• External Obsolescence: Incurable only; loss in value from outside the property such as neighborhood, location, noise, pollution, traffic, etc. Always incurable because the owner has no control of it.

The most difficult step in the cost approach is determining the dollar amount of the depreciation. This is why the cost approach is best suited for new or newer constructed properties. The fewer adjustments that need to be made, the more accurate the appraisal thus for new or newer properties less has to be depreciated. The cost approach is also used for unique properties (e.g. churches, hospitals, municipal building, etc.).

Once an appraiser has a value for the improvements, they will determine the land value separately then add the two together to come up with an estimate of market value according to the cost approach.

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INCOME APPROACH

The income approach is the analysis of the income that a property produces in comparison to its value. Since the income approach is based on income that the property produces, it is best suited for properties that have income (e.g. rentals, apartments, commercial, industrial properties, etc.). There are two ways to calculate value using the income approach:

• Capitalization Rate a.k.a. cap rate: It is a calculation of the rate of return that an investment provides based on its annual net income; In other words, if you buy a property for cash the cap rate is the rate of return that the annual net income provides compared to the price paid; Best suited for larger properties with more income and established, consistent expenses.

• Gross Rent Multiplier: Number used for comparison based off of gross monthly rent; The number does not express anything the way the cap rate does. It is just used for comparison; Best for smaller income producing properties.

For either calculation you start with the cap rate or gross rent multiplier of comparable properties. These will provide the necessary numbers to compare to as the subject property will only provide income and expenses. The calculations are:

• Cap Rate: First determine annual net income of the subject property. To calculate annual net income determine the annual potential gross income (maximum income the property produces), deduct any vacancy and rent losses to determine the annual effective gross income, then deduct operating expenses. Debt service, depreciation, and capital expenditures should not be deducted with the operating expenses; Next calculate the cap rate for each comparable. To calculate the cap rate take the annual net income divided by the price and multiply by 100 (this makes it a percentage). Once determined reconcile each comparable property (determine the best comparisons to the subject property) to determine the cap rate that should be applied to the subject property; Then take the subject properties annual net operating income and divide it by the applicable cap rate to come up with the estimate of value for the subject property.

• Gross Rent Multiplier: Uses the gross monthly rent; First calculate each comparable properties gross rent multiplier by taking the market price divided by their gross monthly rent; Then reconcile the comparable properties (determine the best comparisons to the subject property) to determine the gross rent multiplier that should be applied to the subject property; Then take the subject properties gross monthly rent and multiply it by the applicable gross rent multiplier to come up with the estimate of value for the subject property.

RECONCILIATIONReconciliation is reviewing, analyzing, and effectively weighing the data gathered and using the most applicable information to estimate the market value of the subject property. Reconciling is not averaging. For each appraisal all three approaches to value are completed. Each approach to value is best suited for different types of property. So when an appraiser reconciles the value determined from each approach to come up with the estimate of market value for the subject property, the approach that is best suited for that property will have the most influence on the estimate (e.g. for residential property the best approach will be the sales comparison approach, for properties that produce income it will be the income approach, and for new construction the cost approach will be heavily relied upon).

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THE APPRAISAL PROCESS

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Define the Purpose

Plan the Appraisal

Collect & Analyze Data

Determine Highest & Best Use

Estimate Land Value

3 Approaches to Value

Reconciliation

Prepare Report

• Identify the real estate• Date of the value estimate• Define the value objective

• Identify the data needed• Identify data sources• Develop a time schedule

SPECIFIC DATA• Subject property• Data for 3 approaches to value

Determine Value By• Sales comparison• Cost approach• Income approach

GENERAL DATA• National• Regional• City• Neighborhood• Economic• Social

• Legally permitted• Physically posible• Economically feasible• Maximally productive

• Analyze results• Use best data to determine value

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