valuation appraisals on real estate examinations but don't fret um what's cool about this section is that you're going to have a lot of potential questions uh what's kind of bad about this section is there's a lot of potential questions but if you're kind of guided through and understand where they might lie that's really helpful um over the years I've seen Lots so so just make sure you focus on appraisals and you'll get there so you want to know like what the definition of an appraisal is number one uh that you know couldn't hurt so I would definit have a framework you're going to find it in the book perfect know that you also want to kind of understand three valuation methodologies and those they'll ask you some questions about each one the first one we're going to get into is the sales comparison approach now the sales comparison approach is also known as in some states as the market data approach so that's something you want to know sales comparison approach is the market data approach and basically what's going on here is you have a subject property that you're thinking about let's say buying and the way you can determine what that thing is worth or the way an appraiser might decide what that thing is worth to render their opinion of value don't forget appraisals are just opinions um is they base their opinion supported by evidence they take your subject property and they compare it to other properties that's why they call it the sales comparison approach H sometimes they call them comparables or comparisons or comps uh as as well now what they do is we take the subject properties you're looking in this diagram right here and they're like for example here this one is a three-bedroom two B mostly updated uh on 0.5 acres and they compare it to another property that's similar to now all properties don't look exactly like it so may it may not be the same model of home but if it's in the same geography the same location the same intent of the asset then we're using it as a comp but we have to if you note here this comp has only two bedrooms it has two bathrooms which is the same it has some updates it's on a little bit larger acreage and it's less than a mile away so this is a reasonable comp but we do have a differential between three beds and two beds so we do need to make some adjustments either up and down and subtract value for some of the items and then as we make the adjustments then we reconcile the numbers and then we come to a determination as to what we think our opinion is of what this property is worth okay so that's what we use the sales price of compar able properties are either upped or down we call these adjustments and then the market value of the subject property is the one that we're comparing it to so we're trying to determine what our subject is worth in relation to the other assets this technique the sales comparison approach carries the most weight in residential property valuations and that's an important one so what technique would I use if I were trying to figure out what a 30-year-old single family house uh is worth in like anywhere's Ville USA I'd use the sales comparison approach and then I'd support it with this approach first give it the most weight and then support it by also checking the other two methods if possible to kind of reconcile those numbers and to render my opinion of value sales comparison approach definitely something you'll see this one is called the cost approach to value now cost approach is used to try to determine what something is worth based off of what it might cost to make a reproduction of that thing or a replacement of that thing okay and you know this is what we use in the world of insurance estimating all right so estimates a property's value by determining the cost to replace it minus any depreciation plus the land's value so how do we get to the property value the formula is property value equals the replacement cost of the property to build it less any depreciation plus land value and that gives us the property's value in the cost approach now i' mentioned there are three types of depreciation when it comes down to the cost approach now what is depreciation you want to know the definition depreciation is simply a loss in value for some reason so something that has reduced the value of the asset and it could be something that is physically happening with the property so for example let's say the deck is really old and rickety right and it needs to be replaced well a broken busted up deck is going to lower the value potentially of a property now again it's all relative we can argue this till the cows come home and the reason why is is because you know it depending on the area that this property is with the busted deck it could have no bearing as a matter of fact because it could be a really hot property market so sometimes those things don't always work the way that you might think of them on paper but depreciation physically could be some deteriorating item now if it's within range of cost acceptability then that is a curable item so a physical deterioration for let's say you about a million doll house and the deck's going to cost you $10,000 well it's curable because a $10,000 expense to up date the deck is worth it for a million doll property so that's a curable physical depreciation or deterioration the next one is called functional obsolescence functional obsolescence is a negative reaction from the marketplace because of specific items in the property less desirable items so for example uh let's say if we have a five-bedroom house and we have only one bed bathroom five beds one bath oh that's kind of tough and if there's no way we can plum in another bathroom then the home suffers from an incurable functional obsolescence now if we can put in bathrooms in the space then It suffers from it's still depreciated because it only has one bathroom but if we can add bathrooms and that is a curable functional obsolescence so we can cure that and increase the value if we we need to but again these are depreciations or losses in value and the third one is known as economic or external obsolescence now this one is popular on exams because this one unlike the other two physical and functional which are curable or incurable this one is always incurable so in other words it's a devaluation of my property because of some external Factor so let's say for example the home is a beautiful home but it's in an area where the crime rates are very very high and if you have a property there the value of the asset suffers because of the externalities the things happening around it not the property itself the property could be a gem but it's a gem in surrounded by let's say a tough area and if that's the case then it's going to lose value because of the area now that one is always incurable by the individual inevitably areas can get better the crime rates can drop and things like that can get better and better and then the valuation comes more uh up and up and up okay so those are your three three types of depreciation and that was the cost approach to valuation let's take a quick look at a cost approach calculation all right so suppose it costs $200 per square foot to construct a new building similar to the subject property and a building is 2,000 ft in size the replacement cost would be $200 per square foot times the 2,000 sare ft and we get a cost to replace this structure of $400,000 now we assume that the building has accumulated some depreciation from physical wear and tear which we talked about in the previous module some functional obsolescence and some economic obsolescence uh amounting to about $50,000 so the value of the land is estimated to be about $100,000 so using the cost approach formula which we looked at initially property value equals the replacement cost minus depreciation plus the land remember land does not depreciate so we don't have to depreciate the land so we never subtract out the depreciation from the value of the land so in this example we take the $400,000 and we subtract out 50,000 from the depreciation and then we add in the land value which is $100,000 and that gives us a total property value of $450,000 and this could be some very easy math that you're going to have to do check out the video check out the example and then practice a few inside of the workbooks and you will be golden see you on the next one all right coming up next let's do cap rates and the cap rate is a piece of the third valuation methodology and that's called the income approach to real estate now we use the income approach to real estate when we're trying to figure out the value of an incom producing asset in real estate for example an apartment building would be a utilization of the income approach now if it's a smaller investment property then we have two smaller uh sort of subsections of the income approach one is the gross income multiplier and one is the gross rent multiplier which you'll learn about in a different section but in this one we're going to be talking a little bit about the income approach to valuation and what we utilize for the income approach is something called a cap rate and a cap rate is calculating the capitalization rate it is the rate of return that an average investor would expect to yield by investing their money into this particular type of asset set and again this is where the art sort of meets the science of you know the the sort of the the uh optimism meets the mathematics uh as an investor right some investors when you ask them well what kind of cap rate do you want to yield they're going to say as much as possible obious well obviously as much as possible I I get that but the reality here is we need to have uh an idea of what average cap rates are for these types of assets so if it's an apartment building with x amount of units then doing a little bit of work and research you're going to figure out by asking around what the average cap rates that they are seeing in the industry and being able to have that information readily available so you can apply it to your income analysis and determine what value is based off of the cap rates that you're applying and the adjusted net operating income of the asset so let's kind of get into this calculating the capitalization rate or the cap rate is a method used in real estate to estimate the Investor's potential return on an investment property the formula for cap rate is the following and you should kind of be able to detail tell this for an examination cap rate equals the net operating income or the noi divided by the market value of the property and we can invert these uh mathematically to get to any one we need to solve so just remember sometimes on an exam question they might ask you to determine what is the cap rate they might also ask you to determine what is the market value of the property and they might also ask you what is the net operating income so we need to know how each of them kind of support each other now in calculating the cap rate suppose you are considering purchas a rental property that generates $120,000 in annual rental income after deducting all operating expenses excluding financing costs we don't excl we exclude the mortgage payments the net operating uh income is $80,000 if the current market value of the property is a million you can calculate the cap rate as follows so you take the cap break to try to determine what that is you take $80,000 which is the net operating income after taking out all the expenses and you divide that by $100,000 and that gives you a cap rate of 0.8 or 8% okay the cap rate of 8% indicates an annual return you might expect from an investment a higher cap rate typically suggests a higher potential rate of return let's take a quick uh overview of an example and we'll go through it now we can get a lot more detailed uh and so what you should do is you should go through and look and watch how expenses are taken out and I'm going to be talking about how you don't include the mortgage payment uh and that's a red herring on examinations and that will be further clarified as you're learning more and more but this is to give you sort of a high level overview of how a capitalization rate calculation happens so let's take a look at this example suppose you are considering purchasing a rental property that generates $120,000 annual rental income now we deduct all all operating expenses excluding financing costs the net operating income is $80,000 again this is a very quick a bridged version of detailed analysis now if the current market value of the property is a million dollar you can calculate the cap rate as follows so this cap rate divided by or equals $80,000 divided by the million and that gives us a 08 or 8% cap rate the cap rate of 8% indicates that the annual return you might expect from this particular type of investment a higher cap rate typically suggests a higher potential return okay that was the income analysis in a nutshell and we went through in valuation the three different valuation methodologies good luck on your exam and we'll see in the next one