Study guide
Setting or evaluating a price requires separating what a property is worth from what it happens to sell for, and understanding how a trained appraiser reaches a supportable opinion of value. This chapter also covers a licensee's duty to see that buyers know what they are getting, including the physical condition of the property and any environmental hazards that could affect health or value.
Market Value, Market Price, and the Principles of Value
Market value is an appraiser's opinion of the most probable price a property should bring in a competitive, open market, assuming both buyer and seller are typically motivated, well informed, and acting without undue pressure. Market price is simply the price actually paid in an actual transaction, which may be higher or lower than market value if a seller was desperate or a buyer overpaid in a bidding war. Cost is what it takes to create or replace an improvement and is not the same as value. Several principles explain how value forms. The principle of supply and demand holds that value rises as supply shrinks or demand grows, and falls in the reverse. The principle of substitution says a buyer will not pay more for a property than the cost of acquiring an equally desirable substitute, and it underlies the sales comparison approach. The principle of highest and best use identifies the legally permissible, physically possible, financially feasible, and maximally productive use of a site, which is not always its current use. The principle of contribution measures an improvement's value by what it adds to the whole property, not by what it cost to build; a swimming pool in a cold climate may add less value than it cost to install. The principle of conformity holds that value is maximized when a property is reasonably similar in style and use to its neighbors, while progression and regression describe how a modest home gains value near larger ones, and a large home loses relative value surrounded by smaller, less expensive ones. For value to exist at all, appraisers look for demand, utility, scarcity, and transferability, often remembered by the acronym DUST.
The Three Appraisal Approaches
The sales comparison approach estimates value by analyzing recent sales of similar properties, called comparables, and adjusting for differences such as square footage, condition, and location. The rule of adjustment is to add value to the comparable if it lacks a feature the subject has, and subtract value from the comparable if it has a feature the subject lacks, always adjusting the comparable, never the subject. This approach is considered most reliable for typical residential properties where an active resale market exists. The cost approach estimates value by calculating the current cost to construct a replica or functional equivalent of the improvements, subtracting accumulated depreciation, and adding the estimated land value. It works best for unique or special-purpose properties, such as a church or school, that rarely sell and have few comparables. The income approach estimates value based on a property's ability to generate income, and is most relevant for rental and commercial property. A simplified version divides annual net operating income by an appropriate capitalization rate to estimate value. A related shortcut used mainly for smaller residential income properties is the gross rent multiplier, calculated by dividing sale price by monthly gross rent, or the gross income multiplier, using annual gross income; once a multiplier is derived from comparable rental sales, it can be applied to a subject property's rent to estimate value. Appraisers reconcile the approaches, weighting each based on the property type and the quality of available data, rather than simply averaging the results. Federal oversight, largely through Title XI of the 1989 financial reform law known as FIRREA, requires state licensing or certification of appraisers and independence between loan production staff and the appraiser on federally related transactions.
Depreciation, CMAs, and Assessed Value
Depreciation in the cost approach means any loss in value from any cause, and it falls into three categories. Physical deterioration is ordinary wear and tear, such as a worn roof or aging plumbing, and can be curable, meaning cost-effective to fix, or incurable, meaning not economically justified to fix. Functional obsolescence is a loss in value from an outdated or undesirable design feature, such as a single bathroom in a five-bedroom house, and can also be curable or incurable depending on the cost to correct it relative to the value it would add. Economic obsolescence, also called external obsolescence, is a loss in value from factors outside the property itself, such as a nearby landfill or a declining local economy, and is always considered incurable since the property owner cannot fix an outside factor. A real estate licensee is not an appraiser and does not issue appraisals, but routinely prepares a Comparative Market Analysis, or CMA, an informal estimate of value based on recent comparable sales, active listings, and expired listings, used to help a seller set a listing price or a buyer decide on an offer. A Broker Price Opinion, or BPO, is similar but is typically prepared for a fee at the request of a lender or asset manager, often for properties in default or foreclosure, and generally involves a somewhat more formal inspection and reporting process than a CMA. Assessed value is a value assigned by a local tax authority for property tax purposes and may differ substantially from market value; many jurisdictions apply an assessment ratio or equalization factor to arrive at the taxable value, then multiply by a local tax or millage rate to calculate the annual tax bill.
Seller Disclosure Duties
Most states require sellers to complete a property condition disclosure statement identifying known material defects, such as a leaking roof, faulty wiring, or a foundation crack, though the specific form, required content, and any exemptions are set by state law and are outside the scope of the national exam. As a general national concept, the disclosure obligation typically covers defects the seller actually knows about, not defects a seller should have discovered through further investigation, and it does not substitute for a buyer's own inspection. Licensees representing either side generally share a duty to disclose known material facts that affect value or desirability, and many states extend a duty to disclose material defects a licensee discovers even if the seller did not mention them, though the exact scope of a licensee's independent disclosure duty is also state-specific. Some categories of information, such as whether a property was the site of a death or whether an occupant had a particular illness, are treated very differently across states and are often addressed by so-called stigmatized property statutes; because treatment varies widely, candidates should rely on their state law course for the precise rule and treat this national guide only as a conceptual overview. The universal principle worth remembering is that disclosure duties exist to correct an information imbalance between a seller who has lived in the property and a buyer who has not, and licensees are expected to act honestly and avoid actively concealing a known defect regardless of which state they practice in.
Environmental Hazards and Federal Environmental Law
Several environmental hazards recur throughout national exam content. Lead-based paint was commonly used in housing built before 1978, and federal law requires sellers and landlords of pre-1978 residential property to disclose known lead-based paint hazards, provide any available reports, and give buyers a ten-day opportunity to conduct a lead-based paint inspection before becoming obligated under the contract. Asbestos, once common in insulation and flooring, is a health hazard primarily when its fibers become friable, meaning easily crumbled and released into the air. Radon is a naturally occurring, colorless, odorless radioactive gas that seeps from soil into structures, particularly basements, and is addressed through testing and mitigation systems rather than complete elimination. Mold grows in damp conditions and can trigger allergic or respiratory reactions in sensitive individuals; moisture control is the primary prevention strategy. Underground storage tanks, often found at former gas stations or older properties with buried heating-oil tanks, pose a risk of soil and groundwater contamination if they leak. A brownfield is a property where redevelopment is complicated by the presence or potential presence of contamination, often addressed through federal and state cleanup incentive programs. Properties in a flood zone, as mapped by the Federal Emergency Management Agency, may require flood insurance as a condition of federally related financing. At the federal level, CERCLA, the Superfund law, and its 1986 amendment, SARA, establish liability for cleaning up contaminated sites and can reach current owners even if they did not cause the contamination. Lenders concerned about liability often commission a Phase I Environmental Site Assessment, a records review and inspection identifying recognized environmental conditions; if concerns surface, a Phase II assessment follows with actual soil or groundwater sampling.
Key terms
- Market value
- — An appraiser's opinion of the most probable price a property should bring in a competitive, open market between typically motivated parties.
- Highest and best use
- — The legally permissible, physically possible, financially feasible, and maximally productive use of a site.
- Sales comparison approach
- — A valuation method that adjusts recent comparable sale prices for differences with the subject property.
- Cost approach
- — A valuation method that estimates replacement cost of improvements, subtracts depreciation, and adds land value.
- Gross rent multiplier
- — A factor derived from comparable sales, calculated as sale price divided by monthly gross rent, used to estimate value of income property.
- Physical deterioration
- — Loss in value from ordinary wear and tear on a property's physical components, which may be curable or incurable.
- Functional obsolescence
- — Loss in value caused by an outdated or undesirable design feature within the property itself.
- Economic obsolescence
- — Loss in value from factors external to the property, such as neighborhood decline, always considered incurable.
- Comparative Market Analysis (CMA)
- — An informal estimate of property value prepared by a licensee from comparable sales and listings, not a formal appraisal.
- Assessed value
- — The value a local tax authority assigns to a property for calculating property taxes, which may differ from market value.
- CERCLA (Superfund)
- — The federal law establishing liability for the cleanup of contaminated properties, which can extend to current owners.
- Phase I Environmental Site Assessment
- — A records review and property inspection identifying potential environmental contamination, without physical sampling.
Exam tips
- Keep market value, market price, and cost as three separate ideas; the exam frequently tests a scenario where a price paid clearly departs from value because of a motivated or uninformed party.
- In the sales comparison approach, always adjust the comparable, never the subject: add value to a comparable lacking a feature, subtract value from a comparable with an extra feature.
- Sort obsolescence by location of the cause: physical and functional problems originate inside the property; economic obsolescence always originates outside it and is always incurable.
- Remember the federal lead-based paint rule applies to housing built before 1978 and includes a mandatory 10-day inspection opportunity for buyers.
- A CMA is prepared by a licensee for pricing purposes and is not a substitute for a licensed appraisal; do not confuse the two on exam questions about federally related loans, which require a certified appraisal.