Why is the income approach to value often difficult to use on a single family residential appraisal


What are the capital gains rules as applied to residential property owners?


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1i.You are considering an option to purchase or rent a single residential property. You can rent it for $2,000 per month and the owner would be responsible for maintenance, property insurance, and property taxes. Alternatively, you can purchase this property for $200,000 and finance it with an 80 percent mortgage loan at 6 percent interest that will fully amortize over a 30-year period. The loan can be prepaid at any time with no penalty.

You have done research in the market area and found that (1) properties have historically appreciated at an annual rate of 3 percent per year, and rents on similar properties have also increased at 3 percent annually; (2) maintenance and insurance are currently $1,500.00 each per year and they have been increasing at a rate of 3 percent per year; (3) you are in a 26 percent marginal tax rate and plan to occupy the property as your principal residence for at least four years; (4) the capital gains exclusion would apply when you sell the property; (5) selling costs would be 7 percent in the year of sale; and (6) property taxes have generally been about 2 percent of property value each year. Based on this information you must decide:

a.In order to earn a 10% IRR after taxes on your equity, should you buy the property or rent it for a four-year period of ownership?

b.What if your expected period of ownership was to change to five years. Would owning or renting be better if you wanted to earn a 10% IRR after taxes?

c.Approximately what level of rents would make you indifferent between owning and renting for a four-year period? Assume a 4.5% after-tax IRR would be the minimum you would need to earn on capital invested in the home.


1ii.Why is the income approach to value often difficult to use on a single family residential appraisal?


2i. You are considering the purchase of a property today for $300,000. You plan to finance it with an 80 percent loan. The appreciation rate on the property value is expected to be 4 percent annually for the next three years.

a.Approximate the expected annual average rate of appreciation on home equity for the next 3 years.

b.What if you now think that a $300,000 purchase price may be somewhat high and that if you pay this price, the expected appreciation rates in your house price will be as follows: year 1 = 0%, year 2 = 2%, and year 3 = 3%. How will your answer to part (a) change?


2ii. What are the differences between the cost and sales comparison approaches to appraising property?


3i.You are trying to estimate the value of a property that you are interested in buying. The subject property is located at 322 Rock Creek Road in a new suburb of a large metropolitan area. The property is like many others in the area, with three bedrooms, two baths, a living room, a den, a large kitchen, and a two-car garage. The residence has about 1,800 square feet of air-conditioned space and is of traditional design. The property is located on an interior lot with no potential flooding problems. The quality of construction appears to be about average for the market area.

Comparable properties in  the area have the following characteristics:

Comparable I Comparable II Comparable III
Address 123 Clay st 301 Cherry Lane 119 Avenue X
Sale Price $85,000 $79,000 $75,000
Time of sale 6 months ago 7 months ago 13 months ago
Design Modern Traditional Traditional
Parking 2 car garage 2 car carport 1 car garage
Location Corner lot Interior lot Interior lot
Drainage Good Below average Good
Bedrooms Four Three Two
Baths Two Two Two
Construction Average Average Below average


You have come to some conclusions concerning what you believe the different attributes of the comparable properties are likely to be worth in the market area. Appreciation in house values in the area has been very low over the past eight months, and you think that any properties that have sold within that period would probably not require any adjustments for the time of sale. However, one of the comparable properties sold over a year ago, and you think it will require a $1,500 upward adjustment. You also believe that properties in the area that are located near the creek sell for about $1,200 less than other properties in the area because of a slower rate of runoff after heavy rains. Properties on corner lots generally sell for a premium of about $1,000.

Houses with the fashionable modern design usually bring about $1,000 more than those that have traditional design characteristics. Because three-bedroom homes are considered desirable by buyers in the area, an additional fourth bedroom will generally only add about $1,200 in value to a property. However, properties that contain only two bedrooms are rather difficult to sell, and often bring $2,000 less than their three-bedroom counterparts when they are sold. Most homes in the area have a two-car garage, but when properties have a one-car garage, they usually sell for about $800 less. A two-car open carport generally reduces the value of the property by a similar amount, or $800. The inferior construction quality exhibited by comparable III should reduce its value by about $1,500.

a. You plan to complete the sales comparison approach to value and assign an estimate of value to the subject property. Give specific reasons for your choice of value.

b. Assume that the value of the lot the subject property is constructed on is $13,000. Air conditioned space in the dwelling would cost about $36.00 per square foot to reproduce, and the garage would cost approximately $3,700 to reproduce. Complete the cost approach to value, assuming that, because the property is new, no depreciation of the structure is required.


3ii. What are the capital gains rules as applied to residential property owners?


4i. An investor is considering the acquisition of a “distressed property’’ which is on Northlake Bank’s REO list. The property is available for $200,000 and the investor estimates that he can borrow $160,000 at 8 percent interest and that the property will require the following total expenditures during the next year:

Inspection $500
Title search 1,000
Renovation 13,000
Landscaping 800
Loan Interest 12,800
Insurance 1,800
Property taxes 6,000
Selling expences 8,000

a. The investor is wondering what such a property must sell for after one year in order to earn a 20 percent return (IRR) on equity. What other issues must he consider?

b. The lender now is concerned that if the property does not sell, he may have to carry the property for one additional year. He believes that he could rent it and realize net cash flow before debt service of $1,200 per month. However, he would have to make an additional $12,800 in interest payments on his loan during that time, and then sell. What would the price have to be at the end of year 2 in order to earn a 20 percent IRR on equity?


4ii.List four important drivers of housing demand and price appreciation.


5i. You have an opportunity to acquire a property from First Capital Bank. The bank recently obtained the property from a borrower who defaulted on his loan. First Capital is offering the property for $200,000. If you buy the property, you believe that you will have to spend (1) $10,500 on various acquisition-related expenses and (2) an average of $2,000 per month during the next 12 months for repair costs, etc., in order to prepare it for sale. Because First Capital Bank would like to sell the property as soon as possible, it is willing to provide $180,000 in financing at 8 percent interest for 12 months payable monthly (interest only). Your market research indicates that after you repair the property, it may sell for about $225,000 at the end of one year. Furthermore, you will probably have to pay about $3,000 in fees and selling expenses in order to sell the property at that time.

If you wanted to earn a 20 percent return compounded monthly, do you believe that this would be a good investment? If not, what counteroffer would you have to make First Capital in order to achieve the 20 percent return?


5ii. What are public goods?  How may they be reflected in house prices?


6i. Spreadsheet Problem. Use the Ch7_Rent_vs_Own worksheet in the Excel workbook provided on the Web site. Determine the after-tax IRR for owning versus renting in each of the five years with the following changes in the original assumptions in the spreadsheet:

a.The homeowner has a 15 percent marginal tax rate instead of 28 percent.

b.Rents and property values will not increase over the five years.

c.The loan amount is $105,000 instead of $120,000.

d.The initial rent for year 1 is $15,000 instead of $12,000


6ii. When considering an investment in “distressed” properties, what are the most important areas of research that should be undertaken?


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