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1 Theories & Principles

3.1 Theories & Principles of Appraisal


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Sources: This article contains material from various sources. Among them: The Manual on
Real Property Appraisal and Assessment by DOF/BLGF; various other online articles on
appraisal by several writers. It also contains the editors own elaborate views and opinions.
A. General Concepts
In the Philippines, the professions involved in real property valuation are specified under R.A.
9646 (otherwise known as the RESA Law), and defined as follows
Real estate appraiser performs or renders, services in estimating real estate values,
such services of which shall be finally rendered by the preparation of the report in
acceptable written form.
Real estate assessor works in an LGU to perform appraisal and assessment of real
properties, including plants, equipment, and machinery, essentially for taxation
purposes.
It would seem therefore that the practice of appraisal in our country means valuing real estate.
However, real estate is merely the physical manifestation of something owned or possessed.
The real element that is being valued by a real estate appraiser or assessor is not the real estate
but the real property.
The term Real Property is defined by the IVSC as follows - All rights, interests and
benefits related to the ownership of real estate. Seen in this context, real property includes not
only the tangible elements such as real estate but also intangible forms of real property such as
leasehold rights, franchise contracts, easements, inheritance, etc.
Property is the inherent right of ownership and future benefits of tangible and intangible assets;
any right or interest reflecting a source or attribute of wealth. In the broad definition of IVSC,
the term Property includes real property (or also known as realty), personal property;
businesses and financial interests.
Real property consists of rights in realty. Realty consists of land and all improvements,
synonymous with real estate. Personal property pertains to movable physical assets.
Businesses are entities organized for profit and they could own both realty and personal
properties. Financial interests are shareholdings, securities, and other monetary instruments.
The most common rights of ownership subjected to appraisal are those arising out of the
ownership of real estate. The IVSC defines Real Estate as follows: - Land and all things
that are a natural part of the land, e.g. trees and minerals, things that have been attached to
the land, e.g. buildings and site improvements, all permanent building attachments, e.g.
mechanical and electrical plant providing services to a building, that are both below and
above the ground.

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3.1 Theories & Principles

The 'Bundle Of Rights'


Since value is measured in terms of rights, interests and benefits, it is important to recall the
nature of ownership of real property, the so-called bundle of rights. The Bundle of Rights is a
long-standing concept of ownership in real estate. It is a set of legal rights afforded to the real
estate title holder. The bundle of rights can include the right of possession (the property is
owned by the title holder), the right of use (the owner controls the property's use), the right of
exclusion (the holder can deny people access to the property), the right of disposition (the
holder can buy or sell the property), the right of enjoyment (the holder can use the property in
any legal manner) and the right to recover its fruits. P+U+E+D+E +Rf.
Distinction between valuation and appraisal.
The term valuation is used in a general way. It means to make an estimate of value. The term
appraisal is almost synonymous. Appraisal also means making an estimate of value but this
term is more commonly encountered in statutes together the term assessment. A senior
appraiser explains it like this -In connection with real estate, each property is appraised by the county government, and the
property taxes are based on this value; this determination is always referred to as an
"assessment" and the value is the "assessed value".
The estimate of a property's true market value would be called a valuation to distinguish it from
the assessed (appraised) value; the assessed value is not necessarily a very good estimate of the
current market value.
Thus the real estate agent would speak of the appraisal and the assessed value, and the market
value estimated by a valuation. But this differentiation between appraisal and valuation is
specific to situations of tax assessment; in most cases they are interchangeable.
B. Concepts of Value
The term Value means what a thing is worth.
Value is created by utility, the capacity to satisfy the needs and wants of human societies.
Contributing to its value are a propertys uniqueness, durability, potential, features of location,
relatively limited supply, and the specific usefulness of a given site. The value of real property
depends on the extent of the holders rights or interests. In appraisal, it is necessary to identify
what rights, or what part of the total bundle, are appraised, i.e., which property rights are to be
appraised.
Market Value
Value exists if property has utility, is relatively scarce, arouses the desire of potential buyer to
buy and is backed by purchasing power. There are many types of value. For real estate appraisal
the most common type of value is market value. There are two similar definitions of Market
Value.

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3.1 Theories & Principles

IVSC:
Market Value - The estimated amount for which an asset or liability should exchange on the
valuation date between a willing buyer and a willing seller in an arms length transaction, after
proper marketing and where the parties had each acted knowledgeably, prudently and without
compulsion. (arms length transaction means a transaction between independent, unrelated
parties involving no irregularity.)
MRPAAO:
Market Value is the price agreed upon by the buyer and seller in the open market in the
usual and ordinary course of legal trade and competition; the price and value of the article
established or shown by sale, public or private, in the ordinary way of business; the fair value of
property is between one who desires to purchase and one who desires to sell; the current price;
the general or ordinary price for which property may be sold in that locality.
Other Types of Value
Besides Market Value, there can be other types of value, depending on the intended use. Most
of these other types of value are called Non-market values because they do not reflect fair
value obtained from the free market.
According to the IVSC, the circumstances during which non-market values occur are when
1) A thing is valued primarily for the benefit that an owner inherently enjoys;
For example: The value of a church as a place of solace and worship can not be derived from
market conditions. It is inherent in this type of property.
2) The reasonable price agreed is between two specific parties only;
For example: A price for a building is agreed upon between the company and another company
which are both subsidiaries of the same holding or parent company. There being no armslength relationship, this value could be influenced by other special considerations during
negotiations.
3) Value determined by statute or contract. Examples of this abound zonal values
prepared by the BIR are fixed (Revenue Regulations made by the CIR/DOF) or fair market
values prepared by the LGU are fixed (SFMV enacted by ordinance).
Many types of values are derived from market values and adjusted for special purposes such as
Insurable value, Investment value, Asset exchange value, Going concern value, Liquidation
value, Residual value, Reversion value, Salvage value, Special value, Synergistic Value, etc..
Asset exchange value a value given to a physical asset when it is to be exchanged for
other physical assets or financial instruments.
Going Concern - A business enterprise that is expected to continue operations for the
foreseeable future. Any future economic benefit arising from a business, an interest in a
business or from the use of a group of assets which is not separable.

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Liquidation Value - The net amount that would be realized if a business is


discontinued and its assets are sold individually. The appropriate bases of value and any
appropriate additional qualifying assumptions should also be stated.
Residual Value
1. The anticipated value of an asset at the expiration of its useful life.
2. IFRS definition (IAS16): The estimated amount that an entity would currently
obtain from disposal of an asset, after deducting the estimated costs of disposal, if the
asset were already of the age and in the condition expected at the end of its useful life.
The application of the IFRS definition is described in IVS 300 Valuations for Financial
Reporting.
Reversionary Value - The estimated value of an investment property at the end of a
period during which the rental income is either above or below the market rent.
Salvage Value - The value of an asset that has reached the end of its economic life for
the purpose it was made. The asset may still have value for an alternative use or for
recycling.
Special Value - An amount that reflects particular attributes of an asset that are only of
value to a special purchaser.
Synergistic Value - An additional element of value created by the combination of two
or more interests where the value of the combined interest is worth more than the sum
of the original interests.
Factors of Value: (DUST)
First and foremost, any real estate property has inherent value because of its unique
characteristics. Such a property exhibits certain basic factors of value
1) Demand (desire and purchasing power) satisfy buyers desires within their purchasing
power;
2) Utility (product) the products features that meet buyers needs;
3) Scarcity (supply) less supply gives higher value;
4) Transferability (supply) transfer of use, occupants, ownership, or liquidity; easy to resell.
Forces Influencing Value (PEGS)
Values in real estate are constantly changing. This is due to outside or external forces which
may be categorized into four:
1) Physical or Environmental Forces
a. Climate; b. Soil fertility; c. Mineral resources; d. Community factors transportation,
proximity of schools, churches, parks and recreation areas; e. Flood control and soil
conservation; f. Soil characteristics (subsoil)

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3.1 Theories & Principles

2) Economic Forces
a. Natural resources- quantity, quality, location, rate of depletion; b. Commercial and industrial
trends; c. Employment trends and wage levels; d. Availability of money and credit; e. Price level
interest rates, tax burdens; f. Other factors affecting purchasing power
3) Governmental or Political Forces
a. Zoning Laws; b. Building Codes; c. Police and fire regulations; d. Rent controls, special use
permits, credit control; e. Government sponsored housing and guaranteed mortgage loans;
f. Monetary policies affecting free use of real estate including taxation
4) Social Forces
a. Population growth and decline; b. Shift in population density; c. Changes in family size; d.
Attitudes toward education and social activities; e. Attitudes toward architectural design and
utility; f. Other factors emerging from human social instincts, ideas and yearning
C. Principles Relating to the Market Value
In order to better understand the theories of valuation, it is vital to recognize basic principles
that have been observed at play in a free market economy. Valuers have defined them as follows
-1. Principle of Supply and Demand value is determined by the interaction of the forces of
supply and demand in the appropriate market as of the date of appraisal.
2. Principle of Highest and Best Use it is the use from among all reasonable, probable,
and legal uses that is found to be physically possible, appropriately justified, and financially
feasible and which results in the maximum property value.
3. Principle of Substitution states that a prudent purchaser would pay no more for a
property than the cost of acquiring an equally desirable substitute in the market. Substitution
may take the form of: acquiring an existing property with the same utility (basis for the market
approach), or producing a substitute property with the same utility (basis for the cost approach),
or acquiring investment which will produce an income stream of the same size with the same
risk (basis for the income approach)
4. Principle of Contribution the value of an agent in production or a component of a
property depends on how much it contributes to the whole, or how much its absence detracts
from the value of the whole.
5. Principle of Competition holds that profit tends to breed competition and excess profit
tends to ruinous competition.
6. Principle of Increasing and Decreasing Returns when successive increments of one
or more factors in production are added to a fixed amount of the factors, there is a resulting
enhancement in income up to a point of maximum returns. Any incremental addition thereafter
results in a diminishment of income.
7. Principle of Balance - balance among the factors of production is achieved at the point of
diminishing returns, which is the point of maximum value.

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3.1 Theories & Principles

8. Principle of Change change is inevitable and constantly occurring


9. Principle of Anticipation value is created by the expectations of benefits to be derived in
the future. Value is dependent on the future, not the past: Past experience is useful for
indications of future trends and conditions that it may provide.
10. Principle of Conformity maximum value is realized when a reasonable degree of
homogeneity and compatibility is present. Over improvement, under improvement or misplaced
improvement may be reasonable for non-conformity within a property or its environment. This
principle works in conjunction with:

Progression between dissimilar properties of the same type, the value of the lesser
property is enhanced by the presence of the superior.
Regression between dissimilar properties of the same type, value of superior
property is affected adversely by the presence of the inferior.

11) Principle of Consistent Use both land and improvements are valued assuming the
same HABU.
12) Principle of Externalities external forces affect value: social, economic, physical
environment, and government;
13) Principle of Economies of scale the greater the volume, the less the incremental cost
for additional volume;
14) Principle of Surplus productivity : 4 factors of productivity paid in this order Labor,
capital, entrepreneurship, land + improvements (residual value)
15) Principle of Bite-Sizing smaller portions, can be priced higher per unit of measure, but
may be more affordable to Pinoy buyers. Pinoy buyers tend to buy in tingi or small portions,
especially with respect to real estate.
D. Introduction to the Approaches to Value.
There are three commonly used approaches in valuation
1. Market Data Approach;
2. Cost Approach; and
3. Income Approach.
They are briefly introduced and explained below. Each of these approaches require the use of
methodologies or analytical techniques. The detailed explanation of these approaches and
methodologies are covered by a separate chapters in this Manual.
1. The Market Data Approach
The Market Data approach is also called the Sales Comparison approach. They are
synonymous. The Market Data approach is useful when there is an active market with sufficient
quantities of reliable data which are verifiable by authoritative sources, otherwise it is
unreliable. Information should include age, size location and other factors pertinent to a
comparison with a property exchanging in the market.

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Market analysis may be made on a direct or comparative basis. Direct matching - property with
an identical or nearly identical property; Comparable matching - property with a similar
property.
After market data have been accumulated, adjustments must be made on the indicated selling
prices for differences in physical characteristics, market condition and terms of sale. An
adjustment is an amount which is added to or subtracted from the selling price of a comparable
property to reflect the value of differences identified between the comparative property and the
subject property.
Because valuation depends on market transactions, it is obvious that the principles of
Substitution, Change and Competition are at work. The Market Data approach is used
mostly for valuing land and not very useful for valuing improvements because of the lack of
comparables.
2. The Cost Approach
For valuing property improvements, where market data is insufficient or unreliable, the valuer
can derive his own cost estimate of the property. The starting point of the cost approach is the
assembly of property facts and cost data. These are combined in the cost estimating process to
develop a reproduction cost new (RCN) or cost of replacement (COR).
Reproduction Cost New (RCN) - cost of producing or constructing the property in like kind
at current prices same materials, standards, design, and quality; a replica..
Cost of Replacement (COR - cost of producing or constructing a property of equivalent
utility at current prices
After the RCN or COR is obtained, an amount or factor called Depreciation must be
considered. This is because the replacement cost estimate is that for a brand new improvement
while the subject property for valuation could be of a certain age.
The estimate of fair market value by the cost approach is summarized as follows:
Current Reproduction Cost New or Cost of Replacement
Less: Physical Deterioration: Curable and Incurable
Less: Functional Obsolescence
Less: Economic Obsolescence; Generally Incurable
Plus: Value of Land
Results in: Indicated Fair Market Value
Accountants will usually ask: Why not use the book value of the improvement? The obvious
answer is that doing so will not yield a market value. The acquisition cost of years ago is no
longer representative of todays value because of inflation. Thus the starting point for market
valuation must be the replacement cost new.
C. The Income Approach
In this approach, an estimate is made of the prospective economic benefits of ownership. This
approach is predicated on the proposition that an informed purchaser would pay no more for a

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3.1 Theories & Principles

property than the cost of obtaining an income stream of the same size and embodying the same
risk as that involved in the subject property. Principles of substitution and anticipation apply.
The income approach is particularly applicable when the future benefits of ownership may
reasonably be estimated in the light of related risks to be incurred. The approaches selected
must be supported by the facts and circumstances of the case on hand. The applicability of any
approach in a given valuation problem depends on the character of the problem, the type of the
property involve, the nature of the market and, of course, the availability of the required data of
appropriate quality and in sufficient quantity.
1. Steps involved in translating the net income projection into a value indication
a. Estimate potential gross income;
b. Estimate and deduct a vacancy and collection loss allowance to derive the effective gross
income;
c. Estimate and deduct expenses of operation to derive net operating income (before debt
burden);
d. Estimate remaining economic life of the duration and pattern of the projection income
stream;
e. Select an applicable capitalization method and technique; develop the appropriate rate or
rates;
f. Complete the necessary computations.
2. Capitalization Process
a. Capitalization defined Capitalization is the mathematical process that translates or converts
net income into an indication of value.
b. The formula to derive capital value is: V = I / R; where V = value; I = net income;
R
=
cap rate.
Reconciliation of the Three Approaches to Value
Reconciliation is the final step in estimating value. It is the process of relating the data gathered,
developing the three standard approaches to value, analyzing and weighing the strengths and
weaknesses of each approach, and determining which approach is best supported. Ultimately,
the most relied upon approach will be the most dependable.
E. Introduction to Real Estate Market Analysis Concepts
In the Market Data approach to valuation, the valuer may need to make a market analysis. This
is usually necessary for large projects or in mass appraisal assignments of assessors. A few
important concepts are introduced below. The initial step in market analysis is to identify the
coverage or size of the market to be analyzed. The market size could either be contained in the
following
Groupings of properties
1) Zones or district group of homogenous land uses residential subdivision, industrial
zones;
2) Neighborhood a group of complementary land uses. Community facilities + residential
subdivision lots. Linkage connecting complementary uses to homogenous land uses.

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After deciding on the market size, then it is necessary to examine the community and identify at
what stage of its economic life the entire area has reached
The 4 life cycle stages of a community are
1) Growth; 2) Stability; 3) Decline; 4) Revitalization.
Market analysis can be simple or complex, depending on coverage and expected output. The
three types of market analysis are:
The 3 Types of Market Analysis:
1) Market study not site specific; general study of the market, buyers, sellers, tenants..
2) Marketability study relates to a specific product within a defined market; both site
specific and property type specific; studies absorption time, pricing levels.
3) Feasibility study comparison of cost vs value; cost feasibility is part of HABU.
EXERCISES
Q. The fundamental
consists of

scope of a valuation assignment given to an appraiser

A. Making a listing of the real estate properties of the client in order to present it to potential
buyers;
B. Defining and estimating the value of the rights and interest of a client over some realty
C. Evaluating the physical condition of a property in order to prepare the terms of reference for
future repairs.
D. Determining the veracity of the title and all its related documents to prove rightful
ownership.
Q. The Appraiser was requested to value an existing building on which there exists
a long-term lease contract of 25 years with a foreign embassy because the Owner
plans to sell the property. He can refuse the assignment for the following reason
A. Making a value estimate might prejudice the rights of existing long-term tenant.
B. The Client refused to divulge the commercial terms of the long-term lease to him because it is
confidential.
C. It is impossible to predict the value of the property that is under an encumbrance such as a
long-term lease.
D. The property may not be accessible for inspection because the lessee will not permit it.

Q. A building that is already 50 years old is no longer being used. It requires


substantial restoration and renovation work which the Owner no longer wants to
undertake. The Appraiser is asked to value its

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3.1 Theories & Principles

A.
B.
C.
D.

Salvage value
Liquidation value
Residual value
Reversionary value

Q. In the broad definition of Property, the following is not included by IVSC


A. Real property
B. Intellectual property
C. Personal property
D. Businesses and financial interests
Q. An appraisal made for the purpose of determining a fair compensation for
private property to be acquired for use of the government.
A. Assessment appraisal
B. Expropriation appraisal
C. Foreclosure appraisal
D. Zonal value appraisal
Q. The value of a property which is inherent by its nature or its location and is not
affected by external forces.
A.
B.
C.
D.

Synergistic value
Basic value
Inherent value
Sentimental value

Q. ABC Company, manufacturer of shoes in Marikina, closed its business and sells
its factory, building and equipment. What kind of value?
A.
B.
C.
D.

Fair market value


Salvage value
Asset value
Liquidation value

Q. The principle which states that value will change due to the changes in supply
and demand, time, and market conditions.
A. Principle of balance
B. Principle of anticipation
C. Law of supply and demand
D. Principle of change
E. Principle of conformity

Q. The value of a portion of the property when it provides a function that is as an


indispensable component of the entire property -A. Competition
B. Highest and best use
C. Supply and demand
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3.1 Theories & Principles

D. Principle of changeE. Principle of contribution


Q. Legally permissible, physically possible, financially feasible and maximally
productive -A. Competition
B. Highest and best use
C. Supply and demand
D. Principle of change
E. Principle of conformity
Q. Increasing the number of houses for production using precasting technology
will reduce the unit cost of each house due to the principle of -A. Externalities
B. Economies of scale
C. Supply and demand
D. Increasing/diminishing return
E. Surplus of productivity
Q. Forces that affect the value of a property because of its poor location and
irregular terrain -A. Physical
B. Environmental
C. Government
D. Social
Q. An element of value not favorable to real estate products because of they are
considered immovables.
A. Demand
B. Utility
C. Supply
D. Transferability
Q. Which is not part of the life cycle of a community
A. Growth
B. Stability
C. Inflation
D. Decline
E. Revitalization

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