RPV 1

Rea Property Valuation(LaSu-4083)
Abay A
WGCF&NR, HU
WONDOGENET,
Ethiopia
MAR, 2022/23
Abay A
1
(LaSu 4083)
1. course Introduction
• Course title: RP Valuation

• course No: (LaSu-4083)
• Credit hours: 6 ECTS
1.1 course Outcomes:
By the end the course students will be able to:
• familiar with various concepts of value;
• Being able to logically gather and analyze data that is relevant to valuation of
property;
• Understand the steps to conduct property market analysis.
• Understanding the various methods of valuing property
• Understand how to write a professional property valuation report;
• Explaining their work to others, how their own value decisions are reached
with accuracy and clarity at a seminar, making it a sound basis
• Know and realize the ethics in property valuation; and
• Understand the real practice of property valuation in Ethiopia.
Abay A
2
(LaSu 4083)
1.2 Course Contents:
1. PROPERTY VALUATION
• Meaning of property valuation
• Type of valuation
• Who and how valuations are used
• Misconceptions about valuation
• Philosophical basis for valuation
2. THE VALUATION PROCESS
• Steps of valuations process
• The three classical approaches to value
Abay A
3
(LaSu 4083)
3. REAL PROPERTY MARKET ANALYSIS
• The Essence of Real Property market Analysis
• Basic Market Analysis concepts and Characteristics
• Real property market and participants
• Levels and types of real property market analysis
• Market study and feasibility study
• What should a Market & Feasibility Study Contains
• The Value of The Feasibility Study
• Who Use Market Analysis
• The Good & the Bad on Market Studies
• Using analysis effectively

• Factors Affecting Market Analysis
• The Analytical Process
• Market analysis and business planning
• The Key to Market Analysis: Demand & Supply,
11/23/2023
Abay A
4
(LaSu 4083)
4. THE SALES COMPARISON APPROACH
• Collecting comparable sale data
• Analyzing and adjusting comparable sales
• Method of comparison sales
• Selecting and using units of comparison
• Arriving at estimation of market value of the
subject property
5. VALUING LAND
• Purpose of land ( site value) estimates
• The four methods used to value land
• Market comparison techniques used to value land
11/23/2023
Abay A
5
(LaSu 4083)
6. REPLACEMENT COST METHOD
• Use of cost estimate in valuation
• Cost –estimating methods
• Estimating loss in value
• Accrued depreciation
• UNIT 7 THE INCOME APPROACH
• Income capitalization techniques
• Idea and supposition of capitalization Direct
• capitalization model
• Discount cash flow model
• Market value of the property by using direct
capitalization model and discount cash flow model
Abay A
6
(LaSu 4083)
8. RECONCILING AND REPORTING APPRAISAL
• Reconciling the value approaches
• Form and contents of appraisal reports
• Ethics in property valuation
9. PROPERTY VALUATION IN ETHIOPIA
• Real property valuation practices and its limitations
• Types and Purposes of valuation
• Statutory- done according to provision of
legislation like for expropriation, tax rating etc
• Non-statutory-done for market oriented activities like
mortgage, sale, purchase etc
• Valuation methods
• Limitations and challenges of valuation
Abay A
7
(LaSu 4083)
1.3 Didactic Methods:
• Interactive lecture,
• Group work and presentation,
• seminar and exercise
Abay A
8
(LaSu 4083)
Mode of Assessment:
• Quiz (I & II): (20%)
• Assignments (Home take/ reading, Reporting)
• Group: (10%)
• Individual: (10%)
• Presentation: (10%)
• Final Exam: (50%)
11/23/2023
Abay A
9
(LaSu 4083)
1.6 Module Policy
• Attendance is mandatory
• Expectation for Classroom Behavior
• Contribute in class discussion
• Meet assignment deadlines
• Courtesy and respect
• Discipline
• Punctuality
• Cell phones must be switched off
• Late submission is not acceptable
• Plagiarism
• will disqualify your assignments
• Missing Exam and Tests (medical case &
emergency only)
• Need to be supplemented by relevant documents
Abay A
10
(LaSu 4083)
UNIT
I:Theoretical
…end of this course, students should be able to apply
Objectives of the Course
At the
their previous knowledge of property market and property
investment analysis to valuation of property and to
demonstrate understanding of the valuation process by:
becoming familiar with various concepts of value;
being able to logically gather and analyze data that is

relevant to valuation of property;
understanding the various methods of property valuation

1
and distinguish the conditions under which each method
1 can be applied;
Abay A 11
(LaSu 4083)
UNIT
I:Theoretical

…
Understand how to write a professional property valuation
report;
Explaining their work to others, how their own value
decisions are reached with accuracy and clarity, making it a
sound basis for investment decision making;
Know and realize the ethics in property valuation; and
Understand the real practices of property valuation in
Ethiopia
This course provides basic definition, concepts and

philosophical basis for valuation, steps in valuation process
and the three basics approaches to property valuation, the
2 process of reconciliation, reporting value opinion and
1
property valuation practices in Ethiopia.

Abay A 12
(LaSu 4083)
UNIT I:
THEORETICAL BASIS OF VALUATION
1.1 Introduction
In our complex society, there are various occasions when formal or
informal appraisals are needed.
Such occasions can be divided in to two major categories:
 market transactions and
 legal transactions
Most of the market transactions requiring valuations are connected with
sale,
 purchase,
finance/mortgage, etc
1
3
Abay A 13
(LaSu 4083)
Cont.
In legal transactions, our society requires valuations for different
purposes, including
expropriation and compensation
various taxation purposes, and
use as evidence in civil lawsuits involving real property
1
4
Abay A 14
(LaSu 4083)
Cont.
What is property valuation/property appraisal?
Property valuation/property appraisal is the act or the process of developing an
opinion of property value.
It involves selective research into appropriate market areas, assemblage of
pertinent data, the use of appropriate analytical techniques, the application
of knowledge, experience and professional judgment to develop value
opinion.
It is not simply a mathematical process. It is much more than that, and probably
the larger part of the valuation process depends upon the appraiser forming
opinion.
The appraiser has to look at a wide range of facts and try to
predict the future.
1
5
Abay A 15
(LaSu 4083)
Cont.
It is some times said that valuation is an art and some times that
it is a science. In fact, it is a mixture of both, an art and a science.
The scientific part of valuation is
 the analysis of data and
 the mathematical calculation of data;
The art is the skill of knowing which information to use to assist

valuation and the process of making judgments and forming opinions.
Abay A 16
(LaSu 4083)
1.2 Real Estate, Real Property and Personal Property
 An important distinction is made in between real estate and real property in real estate
valuation.
 Even if these concepts are different, some countries laws and court decisions treat them as
similar for legal purposes.
Real Estate
 Real estate is the physical land and the fixtures attached to the land,
e.g, structures.
 It is immobile and tangible.
 The legal definition of real estate includes:
 Land
 All things that are a natural part of land such as trees, minerals
 All things that are attached to land by people, such as buildings, improvements
Abay A
17
(LaSu 4083)
Cont.
All permanent building attachments like plumbing, electrical wiring, heating
system etc, as well as built- in items such as cabinets and elevators are usually
considered as part of real estate.
Real estate includes all attachments above and below the ground.
Real Property
 Real property includes all interests, benefits, and rights inherent to
the ownership of physical real estate.
The total range of ownership of interests in real property is called
bundle of rights.
9
Abay A 18
(LaSu 4083)
Cont.
It contains all the interests in real property including the right to
use real estate
sell real estate
rent and lease real estate
enter in it and give it away
Each right can be separated from the bundle and can be traded in the market.
Real estate appraisers not only distinguish between real estate and real
property but also differentiate between real estate, personal property and
trade fixtures.
10
Abay A 19
(LaSu 4083)
Personal property
It includes movable items of property that are not permanently affixed to,
or part of, the real estate. Examples:
furniture and furnishings not built into the structure such as refrigerators and
freestanding shelves,
items such as bookshelves installed by a tenant that, under specific lease
terms, may be removed at the termination of the lease.
Trade fixtures
Unlike fixtures, which are regarded in law as part of the real estate, trade
fixtures are not real estate endowed(gifted) with the rights of real property
ownership.
They are personal property regardless of how they are affixed.
20
Abay A 20
(LaSu 4083)
Cont.
A trade fixture is to be removed by the tenant when the lease
expires.
Examples of trade fixtures:
 Restaurant booths
 Gasoline station pumps
 Storage tanks
 Fitness equipment in a health club
 Plumbing, lightening, heating, and air conditioning in an
industrial building
21
Abay A 21
(LaSu 4083)
1.3 Purpose of Valuation
Valuation is the art or science of estimating the value of a property for specific
purpose.
The expression specific purpose refers to the fact that properties may be used for
different purposes such as
 Residential
Commercial
Industrial etc
This means there is a wide range of reasons for requiring valuation of a property.
22
Abay A 22
(LaSu 4083)
Cont.
 It is possible to have different values for one property at one particular moment in time
depending up on the purpose of the valuation.
 The purpose for which valuation is required and the type of property that is to be valued will
determine the nature of the valuation instruction, including the techniques employed and the
basis on which value is to be determined.
 Purpose for which valuation may be required include :
Transfer of ownership
 To help prospective buyers set offering prices
 To help prospective sellers determine acceptable selling prices
To establish a basis real property exchange
 To establish a basis for reorganizing or merging the ownership of multiple properties
14
Abay A 23
(LaSu 4083)
Financing and credit
To develop an opinion of the value of the security offered for a proposed mortgage loan
 To provide an investor with a sound basis for deciding whether to purchase real estate
mortgages, bonds or other types of security
 To establish a basis for a decision to insurance
Litigation
 Eminent domain proceedings
 To develop an opinion of market value of a property as a whole before taking
 Te develop an opinion of market value of the remainder after taking
 To estimate the damages to a property created by taking
15
Abay A 24
(LaSu 4083)
Property divisions
 To develop an opinion of the market value of a property in contract dispute
 To develop an opinion of market value of real estate as pert of portfolio
 To develop an opinion of market value of partnership interests
Environmental litigation
To estimate damages created by violating environmental laws
To estimate damages created by environmental accidents
16
Abay A 25
(LaSu 4083)
Tax matters
To develop an opinion of assessed values
 to determine gift and inheritance taxes
Investment counseling, decision making and accounting

 To set rent schedules and lease provisions
 To determine the feasibility of construction or renovation program
To serve the needs of insurers, policy makers, etc
 To facilitate corporate mergers
 To develop an opinion of liquidation value for forced selling or
auction proceedings
 To advise clients by considering their investment goals, alternatives,
17 resources, constraints and timing of their activities
Abay A 26
(LaSu 4083)
Cont.
 To advise zoning boards, courts, planners on the probable effects of proposed
actions
 To assist in arbitrating valuation issues
 To analyze supply and demand trends in a market
27
Abay A 27
(LaSu 4083)
1.4 Nature of Value
1.4.1 Distinction among Price, Cost and Value
Market- is a set of arrangements in which buyers and sellers are brought
together through the price mechanism.
 Markets exist in many forms.
 A market may be defined in terms of :
 Geography
 Products or product feature
 Number of available buyers and sellers
 Or some other arrangements
28
Abay A 28
(LaSu 4083)
Cont.
A Real estate market is a market formed by the interaction of individuals who
exchange real property rights for other assets such as money.
Specific real estate markets are defined on the basis of
Location
Property type
Income producing potential of the property
Typical investor characteristics
Typical tenant characteristics
Other attributes recognized by those participating
20
Abay A 29
(LaSu 4083)
Cont.
Appraisers have to make careful distinctions among the terms price, cost and
value.
Price –a particular purchaser agrees to pay and a particular seller agrees
to accept under the circumstance surrounding their transaction.
Once finalized, price refers to a sale or transaction price and implies
an exchange. It is an accomplished fact.
Cost: - appraisers used the term cost in relation to production, not in
exchange.
Cost may be either an accomplished fact or a current estimate
In real estate market, cost represents the total expenditure incurred on
 construction and
 development of real estate.
30
Abay A 30
(LaSu 4083)
Cont.
 Construction cost normally includes the
 direct costs of labor and materials,
indirect costs which are expenditures that are necessary for construction but
are not typically part of construction contract. Example: Architectural fees,
property taxes, administrative expenses, marketing costs, etc
Development cost is the cost to create a property, including the
land, and bring it to an efficient operating state.
It includes
 acquisition costs,
 actual expenditures, and
the profit31
required to compensate the developer
Abay A 31
(LaSu 4083)
Cont.
Value: - the relationship among price, market and cost includes the
concept of value.
 Value can have many meanings in property valuation.
 The applicable definition depends on the context and usage.
 In the market place, value is usually considered as an anticipation of benefits to

be obtained in the future.
 Since value changes over time, valuation reflects value at a
particular point in time.
32
Abay A 32
(LaSu 4083)
Cont.
 Value as a given time represents the monetary worth of property, goods, or
services to buyers and sellers.
 To avoid confusion, appraisers don’t use the word value alone.

Instead, they use the word
 market value
 use value
 investment value
 assessed value and other specific kinds of value.
33
Abay A 33
(LaSu 4083)
1.4.2 Types of Value
Market Value
Market value is the focus of most property valuation assignments.
Several appraisers debate on the definition of the term market value. However,
the definition which includes most widely accepted components of market
value is:
• Market value is the most probable price, as of a specified date, in cash or in

other terms equivalent to cash, or in other precisely revealed terms, for which
the specified property rights should sell after reasonable exposure in a
competitive market under all conditions requisite to a faire sale, with the buyer
34
and seller each acting prudently, knowledgeably and for self interest, and
assuming that neither is Abay
under
A
undue duress.
34
(LaSu 4083)
cont.
This definition indicates the situation that market value is based on the
objective observation of the collective actions of the market.
According to the agency that regulates the Federally Insured Financial
Institutions in the United States:
Market value is the most probable price which a property should bring in a
competitive and open market under all conditions requisite to a fair sale, the
buyer and seller each acting prudently and knowledgeably and assuming the
price is not affected by undue stimulus.
35
Abay A 35
(LaSu 4083)
Cont.
What implicit in this definition are
buyer and seller are typically motivated;
both parties are well informed or well advised, and acting in what they
consider their best interest;
a reasonable time is allowed for exposure in the open market,
 payment is made in terms of cash or in terms of financial
arrangements comparable there to and
the price represents the normal consideration for the property sold unaffected
by special financing amounts and/or terms, services, fees or credits incurred in
the transaction
36
Abay A 36
(LaSu 4083)
Cont.
According to the International Valuation Standards Committee, market value
is defined for the purpose of international standards as follows;
Market value is the estimated amount for which a property should exchange on the
date of valuation between a willing buyer and seller in an arm’s-length
transaction after a proper marketing where in the parties had each acted
knowledgeably, prudently and without compulsion.
Arms-length transaction means a transaction between unrelated parties under

undue duress.
37
Abay A 37
(LaSu 4083)
Cont.
Use Value represents a value of a specific property for a specific use. It is not based on the
highest and best use of the property.
 In estimating use value, the appraiser focuses on the value the real estate contributes to the
enterprise.
 The property designed for certain purpose may have one use value before a major change
and another use value afterward.
 Limited purposes properties such as house of worship, museums, schools, public buildings,
clubhouse etc may be appraised based on their current use.
Investment value- represents the value of a specific property to a particular investor
based on that person’s investment requirement
It shows the subjective relationship between a particular investor and the
given investment.
38
Abay A 38
(LaSu 4083)
Cont.
It differs in concept from market value, although investment
value and market value indication sometimes may be similar.
If the investor’s requirement is typically of the market,
investment value will be the same as market value.
When measured in monetary units, investment value is the price an
investor would pay for an investment in light of its perceived
capacity to satisfy individual’s desire and investment goals.
Specific investment criteria must be known to determine an
opinion of investment value.
39
Abay A 39
(LaSu 4083)
Cont.
Going Concern Value
Going concern- is an established and operating business with an
indefinite future life.
The physical real estate assets of certain property such as
hotels,
motels,
restaurants, and
manufacturing enterprises are integral part of an ongoing
business
40
Abay A 40
(LaSu 4083)
Cont.
The value of such properties (including all the tangible and intangible
assets of the going concern as if sold in aggregate) is referred to as going
concern value.
Going concern value includes the incremental value of the property
associated with the business concern
Assessed value- refers to the value of the property determined for

taxation purpose.
Assessed value can be a percentage of market value or ratio of cost to value
Assessed value may not conform to market value but it is usually
calculated in relation to market value base.
41
Abay A 41
(LaSu 4083)
1.4.3 Factors that Create Value
 There are four interdependent factors which create value of a
property.These are:
 Utility
 Scarcity
 Desire
 Effective purchasing power
Utility - refers to the ability of the product to satisfy human wants, need
or desire.
 All properties have to have utility to tenants, owner investors or owner
occupants. For instance, residential properties satisfy the need for shelter and
commercial properties generate income.
42
Abay A 42
(LaSu 4083)
Cont.
The influences of utility on property value depends on the features
of the property. Size utility, design utility, location utility and
other forms of utility can influence property value.
Scarcity - is the present or anticipated supply of an item relative to

the demand for it.
If demand is constant, scarcity of a commodity makes it more valuable.
No object including real estate can have value unless scarcity is
coupled with utility.
Desire - An item must be needed by potential buyer to have value.
43
Abay A 43
(LaSu 4083)
Cont.
Effective purchasing power- is the ability of an individual or group of individuals to participate
in the market for acquiring goods or services in a market.
 A valid opinion of the value of a property includes an accurate assessment of the
market’s ability to pay for the property.
 The complex interaction of the four factors that create value is reflected in the basic
economic principle of supply and demand.
 The supply and demand for the property, in any given situation, are affected by
the utility of a property,
its scarcity or abundance,
the intensity of human desire to acquire it and
the effective purchasing power
44
Abay A 44
(LaSu 4083)
1.4.4 Forces that Influence Value of a Property
 There are four forces that affect the value of a property.These are
Social forces
Economic forces
Government forces
Physical/Environmental forces.
Social Forces
• The value of a property may be affected by:
 Total population
It’s composition by age and gender
The rate of household formation
The rate of household dissolution etc
45
Abay A 45
(LaSu 4083)
Cont.
Economic Forces
The economic forces that can affect the value of a property
are:
Employment
 Wage level
Industrial expansion
Economic base of the region and the community
 Price level
The cost and availability of mortgage credit
The stock of available vacant and improved property
New development under construction
 Occupancy rate
46
The rental and price pattern of existing properties

 Construction cost etc
Abay A 46
(LaSu 4083)
Cont.
Government Forces-
 The value of a property can be affected by political and legal activities at all levels
of the government.
 Some of the factors which may affect the value of a property are:
Public services such as fire and police protection, utilities, refuse collection and
transport network
Local zoning, building codes
National, state and local fiscal policies
Special legislations that affect value, such as legislation affecting the type of loans, loan
terms, and investment power of mortgage lending institutions.
47
Abay A 47
(LaSu 4083)
Cont.
Physical/Environmental Forces- there are many natural and man made
physical/environmental factors that affect the values of a property.These are:
 Location
 Climatic conditions such as rain fall, snow, temperature, humidity
 Topography and soil type
Natural barriers to future development such as rivers, mountains, lakes,
oceans
 Transportation systems
 Toxic contaminants
The nature and desirability of the immediate area surrounding the property
48
Abay A 48
(LaSu 4083)
Cont.
1.5 Foundations/Principles of Valuation
The major principles that govern property valuation are:
Progression: A property’s value may increase due to the existence of similar
properties in similar locations, containing greater quality.
Regression: A property’s value may decrease due to the existence
of similar properties in similar locations, containing lower quality.
Conformity: A property is most likely to appreciate in value along with other,
similar properties in the same neighborhood.
If the neighborhood consists of 2,000 square feet, three-bedroom, two-bath
homes 10 years old, improving property above that standard may not be
profitable.
40
Abay A 49
(LaSu 4083)
Cont.
 Substitution: A property’s greatest potential market value is limited by the market value of
other, similar properties. A prudent purchaser would pay no more for a home than it would
cost him or her to build another one.
 Change: No condition remains the same indefinitely; change is part of the economic cycle.
Property values are affected by change in several forces.These include
 local economic and demographic trends,
 physical age and condition of the property and surrounding properties,
 character of a neighborhood or city, and
 natural events like disasters
50
Abay A 50
(LaSu 4083)
Cont.
Anticipation: Market value often is affected by expectations about future
events.
For example, if an investor believes that a particular area is likely to
experience growth in the coming years, that would mean property value
would rise in that area.
If rezoning is proposed in an area, properties in the affected area could
experience rise or fall in property value in anticipation of the change.
Contribution: Improvements add to market value of a property as a factor of
current supply and demand, and not necessarily on the basis of actual cost.
51
Abay A 51
(LaSu 4083)
Cont.
 For example, a swimming pool which costs 10,000 birr to install may not necessarily
increase the value of the residential property by 10,000 birr.The contribution of the
swimming pool to the value of the property may be
higher than its cost,
equal to its cost, or
lower than its cost depending on current demand and supply of
residential property in that area.
 Plottage: Land values tend to increase when adjacent lots are combined into single
ownership and put into a single zoning or use.
 Highest and best use: real estate valuation is maximized when land is utilized in the best
possible way.
52
Abay A 52
(LaSu 4083)
Cont.
Competition: Opportunities for profitable investment lead to
competition.That means profit tends to increase competition.
Balance : The principle of balance relates both to the property as well as the
environment in which the property is located. Related to the property itself, this
principle holds that value is achieved and maintained when all elements are in
proper proportion.
Externalities: the principle of externalities holds that factors external to the

property can have either positive or negative effective on its value.
53
Abay A 53
(LaSu 4083)
• 8. Plottage. This principle observes that consistency in ownership of land and zoning or usage, tends to
maximize value. The principle states that, "Land values tend to increase when adjacent lots are combined
into single ownership and put to a single zoning or use. "This phenomenon is observed when a series of
relatively small lots remain under-developed and are eventually purchased by one person or company and
subsequently developed. Each individual would be unable to organize such a development when many
owners are involved.
• 9. Highest and best use. Closely related to plottage is the principle that "Real estate valuation is maximized
when land is utilized in the best possible way." Thus, rich farm land should be used to grow crops and land
located within sight of an interstate freeway is best used for highway commercial zoning. The same
observations apply to all forms of zoning and usage. Real estate valuation is unusual in that sometimes 10
one-acre plots are worth more than one 10-acre plot. An analyst needs to compare land size to proposed land
use, and be prepared to adjust valuation based on a site's variance from the idea.
• This means looking at far more than just zoning and its obvious attributes. Zoning is only one aspect, one
expert has observed:
• How many times have we seen statements in reports that conclude that the highest and best use of a property
is as zoned? Highest and best use, by definition, includes the legal, physical, and economic benefits of
ownership, plus social commitments to a community at large."2
• 10. Competition. The last primary principle of valuation is directly related to the broader concept of supply
and demand. The principle of competition states, "Opportunities for profitable investment lead to
competition." This has ramifications for valuation of all properties. A good idea is going to be imitated or
duplicated. Thus, as long as demand remains unchanged, the emergence of competing properties will tend to
dilute market value for all similar properties.
Abay A 54
(LaSu 4083)
• 6. Anticipation. Real estate investors—like those in all markets—are continually estimating
the future value of properties. The principle of anticipation may be stated as: "Market value
often is affected by expectations about future events." For example, if an investor believes
that a particular area is likely to experience growth in coming years, that would mean
property values would rise. The very expectation actually increases demand, and valuation
rises as a result. The cause and effect can be more immediate than the time it takes for the
cause to occur. If a proposed rezone is in the works, properties in the affected area could
experience rise or fall in property value in anticipation of the change.
• 7. Contribution. This principle acknowledges a limitation on growth in market value, notably
in the case of improvements. The additional market value one may expect from improving
property is not equal to cost, but to the contribution those changes make to actual market
value. Thus, in a low-demand market, an improvement may add only $2,000 to market value
even though actual cost was $5,000. In the case of cosmetic repairs to properties in hot
markets, the opposite effect may be seen as well. Contribution tells us, "Improvements add to
market value as a factor of current supply and demand, and not necessarily on the basis of
actual cost." The principle of contribution can also be defined as being controlled both by
increasing returns and by diminishing returns. In other words, making improvements to
property will cause growth in market value to an extent (increasing returns), but when
improvements exceed that level, return on investment begins to fall (diminishing returns).
Abay A 55
(LaSu 4083)
• 1. Progression. This principle relates to one way in which market values rise.
Expressed as a statement, progression tells us, "A property's value may increase due
to the existence of similar properties in similar locations, containing greater quality."
The idea that a rising tide lifts all ships applies here. In fact, progression is also
expressed by the maxim that you profit in real estate by buying the worst house on a
good block.
• 2. Regression. The opposite rule may work as well. A falling tide can lower all ships
or, as the regression principle reveals, "A property's value may decrease due to the
existence of similar properties in similar locations, containing lower quality." So an
exceptional house may not appreciate as one would expect if and when other houses
—even on the sale block—are outdated, obsolete, or poorly maintained. This concept
is closely related to the third principle in real estate valuation, that of conformity.
• 5. Change. This principle tells us, "No condition remains the same
indefinitely(forever); change is part of the economic cycle." Property values are
affected by change in several ways. These include local economic and demographic
trends, physical age and condition of the property and surrounding properties,
character of a neighborhood or city, and natural events like disasters (hurricanes and
earthquakes, for example).
Abay A 56
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• 3. Conformity. This concept is, "A property is most likely to appreciate(rise) in value
along with other, similar properties in the same neighborhood." So if an investor
spends a lot of money to upgrade a house, for example, conformity may limit the
appreciation regardless of how the work is performed. This relates to construction
materials, age of properties, number of rooms, and overall square footage and style.
If the neighborhood consists of 2,000 square feet, three-bedroom, two-bath homes 10
years old, improving property above that standard may not be profitable. Converting
a home by adding 500 square feet and changing the internal layout to four bedrooms
and three baths could be money poorly spent, based on the principle of conformity.
• 4. Substitution. In real estate, comparison rules the way that valuation trends become
established. Thus, progression, regression, and conformity are primary concepts. A
variation on this theme is that of substitution. This principle is, "A property's greatest
potential market value is limited by the market value of other, similar properties."
Thus, it would not be realistic to judge market value in a vacuum. Without
considering the market value of similar properties located in similar areas, we cannot
accurately analyze market value of any property. This theory is easily observed.
When two similar properties are for sale, the lower-priced one will tend to sell first
and, as a result, the market value of the remaining property may be lowered.
Abay A
57
(LaSu 4083)
UNIT II: The Valuation Process
2.1 Introduction
The valuation process is a systematic procedure that an appraiser follows to
provide answers to a client’s questions about real property value.
It is a model that can be adapted to a wide variety of questions
that are related to value.
It is a systematic and logical method of collecting, analyzing, and processing
data into intelligent and well reasoned value estimates.
58
Abay A 58
(LaSu 4083)
UNIT TWO: The Valuation Process
2.1 Introduction
The valuation process is a systematic procedure that an appraiser follows to provide answers to a client’s
questions about real property value.
It is a model that can be adapted to a wide variety of questions that are related to value.
It is a systematic and logical method of collecting, analyzing, and processing data into intelligent and well
reasoned value estimates.
The valuation process begins when the appraiser agrees to take an assignment and ends when the
conclusions of the appraisal are reported to the client.
Each property is unique, and opinions of many different types of value can be developed for a single
property.
The most common appraisal assignment is performed to render(decide) an opinion of market value.
The valuation process contains all the steps appropriate to this type of assignment.
2.2 Steps of Valuation Process
The valuation process is accomplished through specific steps.
The number of steps followed depends on the nature of the appraisal
assignment and the available data.
Research begins after the appraisal problem has been defined and the
scope of work required to solve the problem has been identified.
The analysis of data relevant to the problem starts with an investigation of
trends observed at the market level: international, national, regional, or
neighborhood.
This investigation helps the appraiser understand the interrelationships among:
 the principles,
 forces, and
 factors that affect real property value in the specific market area
Such trends may include positive or negative percentage changes in property value over a
number of years.
2.3 Purpose of valuation process
I. provides a framework for estimating market value (or other types of value)
II. provides a model for performing

o market research
o analysis of data
o applying appraisal techniques
III. provides a checklist for appraisers and users of appraisal services
IV. Complies(act in accordance) with the Uniform Standards of Professional

Appraisal Practice
Cont..
There are 8 steps in the valuation process
1. Step 1 Definition of the Problem
2. Step 2 Scope of Work
3. Step 3 Data Collection and Property Description
4. Step 4 Data Analysis
5. Step 5 Land Value Opinion
6. Step 6 Application of the Approaches to Value
7. Step 7 Reconciliation(Bringing together) of Value Indications & Final Opinion of

Value
8. Step 8 Report of Defined Value

Cont..
Clarification for 8 steps in the valuation process
Step 1- Definition of the Problem
It includes the following information:
Identify client and intended users
Identify the intended use
Identify the purpose of the assignment
Effective Date of the opinion
 Retrospective(Backward-looking) value opinion ( by using specified historic data).
 Prospective value opinion (estate project that are proposed under construction & under
conversation to a new use).
Identify the relevant characteristics of the property
Assignment Conditions: extraordinary assumption & Hypothetical Conditions
Cont..
 Identification of characteristics of property (including location and property rights to be valued:
• The Real Estate - physical entity
• Location
• Real Property Interest to be Valued
• Bundle of rights which are to be included in the valuation
• Fee Simple, Leased Fee or Leasehold
• Whole Interest
• Partial Interest
• Any personal property, trade fixtures or intangible items
• Easements, Restrictions, Encumbrances, Leases etc.
Step 2 : Scope of work
The amount and type of information researched and the analysis applied in an appraisal
assignment. The appraiser is responsible for determining the appropriate scope of work in the
appraisal assignment, given:
o the client's intended use and
o the nature of the problem to be solved.
In the appraisal report, the scope must be clearly disclosed. An appraiser is responsible to:
1.Indicate what was done and wasn’t done
2. Indicate time spend and area searched for data
3. Help to identify resources and data needed
Step 3- Data Collection and Property Description
Following the preliminary analysis (i.e., the identification of the appraisal problem
and determination of the scope of work), the appraiser should collect data on:
1. the market area(General data)
2. the subject property(specific data), and
3. comparable properties in the market(comparable data)
General data it includes information about trends in the social, economic,
governmental, and environmental forces that affect the value of the property in
the defined market area.
Specific data relates to the property being appraised and to comparable
properties. This data includes
 legal,
 physical,
 locational,
cost, and
 income and expense information about the properties and the details of comparable sales.
Cont..
Data on comparable properties
It can be either:
 general data that an appraiser has on file or
 specific data that must be gathered for a particular assignment.
More often, comparable property’s data is specific supply and demand data that relates to
the competitive position of property similar to the subject in its future market.
Supply data includes:
 The inventories of existing and proposed competitive properties,
 vacancy rates, and
 absorption rates.
Demand data may consist of:
 population,
 income,
 employment, and
 survey data pertaining to potential property users.
Cont..
From this data an estimate of future demand for the present or prospective uses of the
subject property is developed.
The amount and type of data collected for an appraisal depend on:
the approaches used to develop an opinion of value and
the defined scope of work.
In a given valuation assignment, more than one approach to value is usually

appropriate and necessary to arrive at a single value estimate.
Depending on the problems to be addressed, one approach may be given greater emphasis than others in
deriving the final opinion of value.
In conducting a particular appraisal assignment:
 the appraiser’s judgment and experience,
 the quantity of data and
 the quality of data available for analysis may determine which
approaches are to be used.

Step 4- Data Analysis
Once the appropriate data on the market area, subject property, and site has been
collected and reviewed for accuracy, the appraiser begins the process of data analysis.
It has two components. These are:
 market analysis and
 highest and best use analysis(HBUA)
1. Market Analysis
Market analysis is defined as a study of market conditions for a specific type of
property. Broad market conditions provide the background for local and neighborhood market influences that have direct impact
on the value of the subject property.
Market analysis serves for two important functions:
• First, it provides a background against which local developments are considered.
• Second, knowledge of the broad changes that affect supply and demand gives
an appraiser an indication of how values change over time.
The extent of market analysis and the level of details appropriate for a particular
assignment depend on the appraisal problem under examination.
Cont..
2. Highest and Best Use Analysis
Analysis of the highest and best use of the land:
• as though vacant and
• the property as improved is essential in the valuation process.
Through highest and best use analysis, the appraiser interprets the market forces
that affect the subject property and identifies the use or uses on which the final
opinion of value is based. Analyzing the highest and best use of the land helps the
appraiser identify comparable properties.
There are four criteria that highest and best use must meet are legal permissibility,
physical possibility, financial feasibility, and maximum productivity.
1. Legally allowable
Only those uses that are, or may be, legally allowed are potential highest and best
uses.
This may exclude uses that are not allowed by urban planning law(zoning), uses
that are forbidden by government legislations.
Cont..
2. Physically possible
Any potential use must be physically possible given the size, shape,
topography, and other characteristics of the site into account.
3. Financial feasibility
The highest and best use of a property must be financially feasible.
This means that the proposed use of a property must generate adequate revenue
to justify the costs of construction plus a profit for the developer.
4.Maximally productive use
Finally the use must generate the highest net return (profit) to the developer.
Eventually, the Potentially comparable properties that do not have the same
highest and best use are usually eliminated from further analysis.
Estimating the land's highest and best use as though vacant is a necessary
part of deriving an opinion of land value.
There are 2 reasons to analyze the highest and best use of the property as improved:
 is to help identify potentially comparable properties.
 is to decide which of the following options should be pursued:
 Maintain the improvements as it is
 Cure items of deferred maintenance and retain the improvements
 Modify the improvements (e.g., renovate, modernize, or
convert).
 Demolish the improvements.
Step 5- Land Value Opinion

Land valuation is directly related to highest and best use analysis.
From the appraisers’ point of view there is a difference between land
and site.
Land includes the earth’s surface, both land and water, and anything that is
attached to it, whether by the course of nature or by human being.
Site refers to land that is improved , so that it is ready to be used for a specific
purpose. Land value can be a major component of total property value.
Cont..
Appraisers often develop an opinion of land value separately, even when valuing properties with
extensive building improvements. Land value and building value may change at different rates,
because the improvements are almost always subject to depreciation. For many appraisals, a
separate opinion of value is required.
In the valuation process land value estimation is a separate step, which may be accomplished
through applying six different techniques to obtain land value indications. These are:
1. Sales comparison: Sales of similar, vacant parcels are analyzed, compared, and adjusted to
provide a value indication for the land being appraised. The most reliable way to establish land
value.
2. Allocation: Sales of improved properties are analyzed and the prices paid are allocated between
the land and the improvements. Allocation can be used in two ways: to establish a typical ratio of
land value to total value, which may be applicable to the property being appraised, or to isolate the
value contribution of either the land or the building from the sale for use in comparison analysis.
3. Extraction: Land value is estimated by subtracting the estimated value of the improvements
from the known sale price of the property. This procedure is frequently used when the value of the
improvements is relatively low or easily estimated.
Cont..
4. Subdivision development: The total value of undeveloped land is estimated as if the
land were subdivided, developed, and sold. Development costs, incentive costs, and
carrying charges are subtracted from the estimated proceeds of sale, and the net income
projection is discounted over the estimated period required for market absorption of the
developed sites.
5. Land residual technique: The land is assumed to be improved to its highest and best
use. All expenses of operation and the return attributable to the other agents of production
are deducted, and the net income imputed to the land is capitalized to derive an estimate
of land value. An alternative land residual technique is applied by valuing the land and
improvements and deducting the cost of the improvements and any entrepreneurial profit.
The remainder is the residual land value.
6. Ground rent capitalization: This procedure is used when land rents and capitalization
rates are readily available such as in well-developed areas. Net ground rent, the net
amount paid for the right to use and occupy the land, is estimated and divided by a land
capitalization rate. Either actual or estimated rents can be capitalized using rates that can
be supported in the market. This procedure may be seen as an extension of direct sales
comparison but, where applicable, it provides a specific unit of comparison.
Physical factors of land value
• Shape
• Width
• Depth
• Type of Lot
• Topography
Legal factors of land value
1. Legal Entity
2. Zoning
3. Environment
1. Protection
2. Laws
4. Use Restrictions
5. Utilities & Municipal Services
6. Level of Taxes
THE PURPOSE OF LAND VALUE ESTIMATION
1. For sale/purchase purposes.
2. For mortgage purposes.
3. For assessing rental value.
4. For rent restriction.
5. For insurance purposes.
6. For balance sheet/accounting purposes.
7. For taxation purposes e.g. inheritance tax, income tax, capital
gains tax or transfer tax.
Step 6- Application of the Approaches to value
The three important methods/approaches to property value are:
1. Sales comparison approach
2. Cost approach
3. Income capitalization approach
1. Sales comparison approach

The sales comparison approach is most useful when a number of similar
properties have recently been sold or are currently for sale in the subject property's
market.
Using this approach, an appraiser produces a value indication by comparing the
subject property with similar properties, called comparable sales.
The sale prices of the properties that are judged to be most comparable tend to
indicate a range in which the value indication for the subject property will fall.
Cont..
The appraiser estimates the degree of similarity or difference between the subject
property and the comparable sales by considering various elements of comparison:
 Real property rights conveyed
Financing terms
 Conditions of sale
Expenditures made immediately after purchase
Market conditions
 Location
 Physical characteristics
Economic characteristics
Use/zoning
2. Cost approach
The cost approach is based on the understanding that market participants relate
value to cost.
Cont..
Value of a subject property = Estimated land/site value
+
The current cost of constructing a reproduction or replacement
for the improvements
+
Entrepreneurial profit and/or incentive
_
Amount of depreciation in improvements
This approach is particularly useful in valuing new or nearly new improvements
and properties that are not frequently exchanged in the market. The current costs
to construct the improvements can be obtained from:
cost estimators,
cost manuals,
builders, and
 Contractors
3. Income Capitalization Approach
In the income capitalization approach, the present value of the future benefits of property ownership is
measured.
A property's income and resale value upon reversion may be
capitalized into a current value.
There are two methods of income capitalization:

 direct capitalization and
 yield capitalization.
In direct capitalization: the relationship between one year's income and value is reflected in either a
capitalization rate or an income multiplier.
In yield capitalization: the relationship between several years' stabilized income and a
reversionary value at the end of a designated period is reflected in a yield rate.
Cont..
The most common application of yield capitalization is Discounted Cash Flow (DCF) analysis.
The specific data that an appraiser investigates in the income capitalization approach
might include the:
property's gross income expectancy,
expected reduction in gross income caused by vacancy and collection loss,
 anticipated annual operating expenses,
the pattern and duration of the property's income stream, and
the anticipated reversionary value.
After income and expenses are estimated, the income streams are capitalized by applying
an appropriate rate or factor and convert into present value through discounting.
Step 7- Final Reconciliation of Value Indications
The final analytical step in the valuation process is the reconciliation of the value indications derived into a single
monetary figure or a range of values in which the value will most likely fall.
The nature of reconciliation depends on the:
• the appraisal problem,
• the approaches that have been used, and
• the reliability of the value indications derived
The final opinion of defined value, which is the goal of the valuation process, is usually reported as a single
figure or as a range of value or as a value in relation to some stated benchmark amount (i.e., more than or less
than a given dollar amount).
In a perfect world, all the methods used would result in the same value.
Unfortunately, given the property valuation, it is inevitable that each methodology will generate a unique value
estimate that differs from the other methodologies. Thus, appraisers should resolve the difference among value
indicators and end up with a single or a range of values.
Step 8- Report of Defined Value
The appraisal assignment is not complete until the conclusion is stated in a report and presented to the client.
The reported value is the appraiser's opinion and reflects the experience and judgment that has been applied to
the study of the assembled data.
The appraisal report is the tangible expression of the appraiser's work and the last step in the valuation process.
The conclusions of an appraisal ma y be communicated to the client in writing or orally. The appraisal report
must include certain minimum elements that are required to satisfy practical, professional, and legal
requirements.
Standards of Written Reports
The appraisal report leads the reader from the
1. definition of the appraisal problem
2. analysis and relevant descriptive data
3. specific conclusion.
The length, type and content of the appraisal report are dictated by
 the intended use and purpose of the appraisal,
 the nature and complexity of the problem solved.
Unit three
Real Estate Market Analysis
Basic Principles,
Abay A Real Property valuati 84

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• Studies that focus on the market include:
Local economic conditions Analysis
• Study of the fundamental determinates of the demand for all real
estate in the market.
Market Analysis
• Study of the demand for a particular property type with the prospect of
 A site in search of a Use
 A Use in Search of a Site

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Cont.
Marketability Analysis
• Study of a specific development or property to assess its competitive position.
• Studies that focus on individual decisions
Feasibility Analysis
• Evaluates a specific project as to whether or not it is likely to be carried out
successfully
Investment Analysis
• Evaluates a specific property as a potential investment.
• Investor specific.

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Overview of Market Analysis Components
Two Major Study (Question) Types
1. A Site in Search of a Use
2. A Use in Search of a Site
The Study Process
Seller analysis
1. What attributes does the subject property offer to the market?
Buyer Analysis
2. Who are the potential, typical users/most likely purchasers of the subject?

on 2022
Cont.
Demand Analysis
3. Is the property use needed?
Population ?
• Households ?
• Housing Units Income ?
• Effective Buying Power ?
• Retail(Sell) Sq. Ft.
• Jobs ?
• Use Office ?
• Office Sq. Ft.
• Use Industrial ?
• Industrial Sq. Ft.

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Cont.
Supply Analysis
4. What is the Competition?
Equilibrium Analysis
5. Analysis comparing demand and supply
• How much rent can be charges?
• Is the location competitive?
• Are the property attributes competitive?
• How much of the demand can be captured?

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Cont.
Capture Analysis
6. Subjects marketability
Feasibility Analysis and/or Highest and Best Use
7. Does the subject make financial sense?
• Is it a good investment?
• What is its market value?
• Is the property's value more than its cost?
• Is there any entrepreneurial reward for the risk?

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Property Productivity Analysis
Step 1 Define the Product (real estate) on the base of property
characteristic
A. Physical Attributes
B. Legal and Regulatory Attributes
 Private
 Public
C. Location Attributes
• Identification of economic attributes the association between land uses and
their linkages
• Identification of the movement of demand in relation to the direction of urban
growth

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Cont.
• Analysis of Urban Growth Structure

• Pattern,
•Direction and
•Rate
• Analysis of factors influencing urban growth structure
• Natural,
• Manufactured and
• Political
• Identification of competition and comparison of location advantages and
disadvantages between competition and subject.

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Cont.
D. Market appeal(attractiveness) Attributes
• Identification of specific features such as design or
amenities that appeal(call) to market participants

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Step 2 Define the Users Market Delineation
A. Market area concepts
• Time-distance concepts
• Area over which equally desirable, substitute properties tend to compete with the
subject
B. Geographic Market Delineation
C. Identification of Characteristics of Most Probable User (consumer
profile)

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Step 3 Forecast Demand Factors
A. Major demand types
• Population creates households
• Income creates retail buying power
• Employment creates office and industrial users
B. Tastes and preferences
 behavioral,
 motivational, and
 psychological factors
C. Demand segmentation

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Step 4 Inventory and Forecast Competitive Supply
A. Existing stock of competitive properties
B. Potential competition
 Proposed construction
 Probable additional construction
C. Factors influencing completion(achievement) of potential
competition
 Land availability and costs
 Interest Rates
 Material and labor costs
 Entrepreneurship

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Step 5 Analyze the Interaction of Supply and
Demand
Residual Demand Study
A. Competitive environment
• A competitive environment is one in which companies compete with each
other. The more businesses that provide a similar product or service, the more
competitive the environment.
B. Residual Demand Concepts
• An individual firm faces a residual demand curve. This is the market demand
not met by other sellers. It is equal to the market demand minus the supply of
all other firms.

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Marginal Demand Analysis
 Marginal demand is the term in economics that refers to the change in
demand for a product or service in response to a specific change in its price.
 Normally, as prices for goods or service rise, marginal demand falls. And
conversely, as prices for goods or services fall, marginal demand rises.
 A product or service where price changes cause a relatively big change in
marginal demand is said to have an elastic market. A product or service
where price changes cause a relatively small change in marginal demand are
said to have an inelastic market.

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Step 6 Forecast Subject Capture
A. Capture rate and absorption period for subject property
B. Risk Analysis
• Risk analysis refers to the assessment process that identifies the potential
for any adverse events that may negatively affect organizations and the
environment.
• Risk analysis is commonly performed by corporations (banks, construction
groups, health care, etc.), governments, and nonprofits.
C. Reconciliation of market analysis and conclusions

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Market Analysis Levels
• Inferred Demand Studies

Levels A and B
• Emphasis is on knowledge and historical data
• Fundamental Demand Studies
Levels C and D
• Emphasis is on quantifiable data and forecasting

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Level A Market Analysis
• Draws on readily available regional and city data, a general area description
provides the backdrop for the comparable property data used to represent
market conditions
• Analyses are more descriptive than analytical
• Historically oriented rather than future oriented
• Rent and comparable sales are relied upon.

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Cont.
A. Property productivity analysis
• Physical attributes
• Legal attributes
• Location attributes
B. Supply and demand analysis
 Demand
 Supply

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Cont.
C. Marketability/equilibrium analysis/highest and best use
conclusions
 Focuses on use conclusions
 Timing based on analysts feel for the market
 Improved Properties
 Use and timing for property use
 Vacant land or land as though vacant
 Use Usually uses permitted by current zoning
 Timing Considered immediate

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Level B Market Analysis
• Relies upon broadly based surveys of the market for

estimating supply and demand
• Uses quantifiable data as a basis for judgments about highest
and best use and timing

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Cont.
A. Property productivity
• Physical Attributes
• Legal Attributes
• Includes a check for deed restrictions, easements, and other legal
attributes
• Location attributes

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Cont.
• Uses specific quantifiable data for use and timing
• Employs data that relate to timing of demand timing becomes
function of demand relative to supply
• Regional Sales Trends

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Level C Market Analysis
• Employs fundamental forecasting techniques

• Can distinguish whether there is an excess of supply, demand, or
a balanced market

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Cont.

 Physical attributes same as level B
 Legal attributes same as level B
 Location attributes
• Analyzed with a location rating grid to provide some quantified
analysis of the subjects competitive position

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Cont.
• Uses future oriented forecasting techniques for forecasting
demand and supply
conclusions
 Probable use
 Probable use of vacant land

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Level D Market Analysis
Usually handled by professional real estate market analysts

• Includes detailed projections of probable future land uses
• Forecasting demand and supply
C.Marketability/equilibrium analysis/highest and best use
conclusions
• Improved existing or proposed properties
• Vacant land

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Criteria for Selecting Appropriate Level of Market
Analysis
• Prevailing Market Conditions on the Study Date

• Project Type
• Project Size
• Client needs

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Unit 4
Sales Comparison Approach
4.1 Introduction
Sales comparison approach is a valuation technique in which the value of the
subject property is determined by comparing the properties recently sold in
the market to the subject property.
The subject property will be sold for an amount similar to the adjusted price of
the comparable properties.
In this approach is preferable to determine the value opinion of the subject
property when
1. There are sufficient data
2. Recent sold and
3. Reliable market data on properties that are similar to the subject.
11
2
Abay A Real Property

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valuation 2022
Cont.
The appraiser should have recently sold sales data of comparables since
change in market situations may degrade the validity and applicability of
older data.
It is the easiest approach of estimating the value indication when market
data is available.
In using this approach, an appraiser is required to know:
 The comparable properties
 The subject property,
 The neighborhood, city and the region where the property is located.
It is not advisable to use sales comparison approach when there is shortage
of market data on comparables.
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valuation 2022
Cont.
In addition to these, it cannot be applicable for estimating the value of
special purpose properties such as museum since it is difficult to get
market data on comparables.
In this approach, the appraiser has to:
 Verify the market date obtained and
 Fully understand the behavioral characteristic market .
It is also mandatory for the appraiser to recognize and investigate:
 The strength
 Weakness of the data compiled
 The degree at which comparative analysis has been carried out in
the sales comparison.

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valuation 2022
Cont.
• Prior sales or listings of the subject or the comparable sales used in an appraisal may
help to validate the current data.

• For instance, if an appraiser finds a comparable sale that was reportedly sold for
500,000 birr this year but a historical research shows that the same property was sold
last year for only 250,000 birr, the appraiser ought to spend his/her time in
investigating the probable causes of a 100% increase in sale price of the property in
one year difference.
• In most markets, if a property sold for 500,000 birr this year, 480,000 birr before one
year, and 300,00,000 birr before four years, property valuation experts would have
little fear that the current data was reported incorrectly.
11
5

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valuation 2022
Cont.
An appraiser uses sales comparison approach when there is
 Availability of accurate and complete data on comparables
 Recent sales
 Similarity of comparables to the subject property
 Stability of local market conditions, regional and national
economic factors
Relation to Appraisal Principles
The principles on which the sales comparison approach is based
are described as follows.
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6

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Supply and demand
The price of real estate is determined by the interaction of market demand and
market supply of real estate assuming that there are many buyers and sellers that act
for maximizing their interest.
The demand for a property can be estimated considering
 The number of potential buyers of a property,
 Their purchasing power,
 Taste and preferences, etc
Similarly, an appraiser may consider
 The existence of vacant properties
 Properties that are under construction or
 Planned to be constructed in order to determine the supply of a property in the
market.
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7

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Cont.
The price of a subject property and comparable properties may be changed if
there are changes in factors that affect demand and supply of properties.
Substitution
The sales comparison approach is based on the economic concept of
substitution that a knowledgeable and prudent person would not pay more for
buying a property than the cost of acquiring an equally satisfactory property.
This implies that, within a suitable time frame, the values of properties
that are considered to be close substitutes in terms of location, utility and
desirability will tend to be similar.
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8

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Cont.
This principle indicates the situation that the reliability of sales comparison
approach shall be degraded unless there are substitute properties for the subject
in the market.
Balance
The market price of a property is determined by the interaction of market
demand and market supply of a property in market economy.
The market achieves its equilibrium at this point (point of intersection).
Shift in any of the factors that affect market demand (for instance population,
purchasing power, consumer taste) or factors which determine market supply
(like construction of new buildings) of a property definitely disturbs this
equilibrium
.

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Cont.
In addition to this,
 The relationship between land and improvements, and
 Relationship between the property and the environment has to be in balance
so that the value of the property can indicate the optimum market value.
For example, if the property has too much land in relation to its improvement or
too many amenities for its location, an imbalance is created.
Externalities
As it is known, there are several external factors that affect the value of the
property.
Some factors affect value of the property negatively and others may affect it
positively.

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Cont.
The value of a property may vary depending on
 The condition and lighting of the street besides the property,
 The availability of transportation facilities,
 The adequacy of police protection,
 The enforcement of municipal regulations, and
 The proximity to shopping and restaurant facilities.
For example, a property near to the drug addicted area has lower value than
those far from it and a property which is located near to a lake side with nice
view has higher value than other properties.
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1

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Competition
Potential profits attract new buyers and sellers to the market. Competition
among sellers may lead to an over supply/surplus which reduces prices and
profits.
Competition among buyers may lead to shortages which increase price and
profit to sellers.
Relative to property, an excess of one type of facility will decrease the value of
all similar facilities.
Conformity
Conformity is the valuation principle which states that property value is created,
and sustained when there is reasonable similarity among the improvements in
an neighborhood.
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2

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Cont.
Consistent use
The principle of consistent use states that the valuation of the entire property
must be based on a single use.
 It is improper to value the property on the base of one use for the land and
another use for improvements.
This principle is especially important to remember when valuing a property in
transition from one use to another use.
Contribution
The cost of the improvement does not necessarily increase the market
value of the property by the same amount.
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4.2 Applicability and Limitation
Applicability
The sale comparison approach is applicable to all types of property
interests when there are
 Sufficient comparable recent sales and,
 Reliable transactions to indicate value pattern of the market.
The sale comparison approach is the most widely known approach,
and if it is used appropriately and correctly, it is the best indicator of
value for real property.
It is reliable because it is based on verifiable data from arm’s-length
transactions.
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When data on comparable properties are available, this approach is the most
direct and systematic approach to determine the value opinion.
Limitation
However, the applicability of this approach is limited when
1. There are insufficient number of market transactions of comparable
properties.
2. Rapidly changing economic conditions and legislations can limit the
reliability of sales comparison approach.
3. Rapid inflation or deflation can also jeopardize the reliability of an
appraisal’s adjustment.
4. Little comparable data will
5. It is imperative for the appraiser to identify and analyze the strengths
and weakness of the data compiled.
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Cont.
All the relevant facts and opinions must be communicated in the appraisal
report.
Statements concerning
• The availability of data
• The analysis performed and
• The final conclusion of value should be presented in the reconciliation
section of sales comparison approach and, where appropriate, in the final
reconciliation of the value estimate.
Income multipliers, capitalization rates and yield rates which are applied to the
income capitalization approach can be extracted from comparable sales.
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4.3 Procedure in Sales Comparison Approach
An appraiser follows a systematic procedure to apply the sales comparison
approach.
The systematic procedures (steps) that an appraiser should follow in order to
estimate the final opinion of value of the subject property using the sales
comparison approach are described as follows.
1. Research the market for information on sales and listings:

It is the first step of sales comparison approach.
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Cont.
 In this step an appraiser ought to gather data on:
 Sales and contract
 Offers to purchase
 Listing of comparable properties
 The data collected from completed transaction and conducted at arm’s length are
considered as the most reliable source of value indicator as value conclusions must be
market driven.
 Initially, appraisers should research on
 The sales prices,
 Real property rights conveyed,
 Financing terms,
 Motivations of buyers and sellers,
 Dates of the property transaction, and costs incurred immediately after purchase
.

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Cont.
 Next to this, an appraiser should observe each properties location, physical and functional
condition, economic characteristics, use and non-reality components of value.
 Appraisers can obtain the above data from different sources such as
 Buyers and seller of real property
 Brokers
 Public records
 Professional data companies
 Other appraisers
 Real estate periodicals
 Interviews with the parties to transactions, their employees, attorneys,
counselors, appraisers, property managers, lenders
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2. Verify the information:
In estimating the value of the subject property, appraisers are responsible for
providing enough evidence of value to support for value opinion.
Thus, they should verify the information to ensure its accuracy.
For instance, taking three comparable properties may be enough if they are
considered as verifiable and give conclusive evidence of the value opinion.
Otherwise, an appraiser ought to include additional comparable properties to
estimate the value of the subject property using this approach.
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3. Select relevant units of comparison
The units that will be compared must be similar.
Therefore, each sales price should be stated in relevant units of comparison.
Units (elements) of comparison are used to facilitate comparison of the subject
property with the comparable properties.
Units of comparison are generally specific to a particular market.
For instance, the price per square foot of gross building area including
land may be the relevant unit of comparison in some markets.
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Cont.
Units of comparison may be:
• Physical units of comparison such as price per square meter of gross
building area and pries per square meter of net building area
• Income units of competition such as potential gross income multiplier
(PGIM), effective gross income multiplier (EGIM) and net income
multiplier (NIM).
Therefore, an appraiser should select appropriate unit of comparison to reach at
good value opinion of the subject property.
4.Analyzing and adjusting comparable sales

In this step, an appraiser should observe the difference between the comparable
properties and the subject property using the elements

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Cont.
Adjustment can be made either to total property price or to appropriate unit
of comparison.
The following are the basic elements of comparison that appraisers should
consider in estimating the value of a subject property using the sales
comparison approach.
• Real property right conveyed
• Financing terms
• Conditions of sale
• Expenditures made immediately after purchase
• Market conditions
• Location
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Cont.
• Physical characteristics
• Economic characteristics
• Use (zoning)
• Non-realty components of value such as furniture’s and fixtures those are
typical of presently.
5. Reconciliation of value indications in sales comparison

approach
Reconciliation is the last step of valuation in sales comparison approach when
there is two or more value opinions estimated from market data.
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Cont.
These different value estimates are reconciled into range of values or a single
value estimate referred to as point estimate.
In doing this, appraisers have to

 Consider the strength and weakness of each value indication estimated,
 Observe the reliability and appropriateness of the market data
compiled and
 Observe the analytical techniques used.
For example, values opinion estimated based on the area method and
assessment value method must be reconciled into arrange of values or a
single value indication for the sales comparison approach.

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Selection of Comparable Sales
Every property has its own unique feature that makes it different from others.
As a result, it may be difficult to get a recently sold property that is
completely comparable to the subject property.
Thus, an appraiser should collect data that are as similar as possible to the
subject
• In time of sale,
• Location and
• Other essential characteristics.
There is no specific number of comparables that is considered to be right for
every appraisal.
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Cont.
The number depends on the comparability of the sales to the subject property.
Three comparable properties can be enough for estimating the value opinion of
the subject property if they are
• Very similar to the subject property
• Located nearby the subject property and
• Very recently sold
However, large number of comparables is considered to be necessary when

• The sales are assumed to be less comparable or
• The appraiser has less confidence in the reliability of the information
obtained about the sales.
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Cont.
The sales price of a property has to fulfill three different conditions
These are:
Competitive property
A property sold before and considered as comparable should be a reasonable
substitute for a potential buyer looking at the subject property.
Open market transaction
The second condition sale must be an open market transaction
Recent in time of sale
The third condition that a sale has to be considered as comparable is that the
property must be sold recently.

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4.4 The Process of Analyzing and Adjusting
Comparative Sales
It is a rare case that the comparable properties are identical to the subject
property, particularly for nonresidential properties.
Thus, the determinants of property value such as
• Location,
• Physical factors such as size, layout and configuration, quality and
condition of accommodation and
• Legal factors such as ownership type and lease terms need to be quantified,
adjusted and reconciled in determining the value opinion of the subject
property using the sales comparison approach.

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4.5.1 Analyzing Comparable Sales
Each of the basic elements of comparison, used in sales comparison approach,
must be analyzed to determine whether an adjustment is required.
If sufficient information is available, a quantitative adjustment can be made.
If there is insufficient support for a quantitative adjustment, the element of

comparison can be addressed using qualitative analysis.

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Cont.
The most commonly used elements of comparison are explained as
follows:
• Real property rights conveyed
• Financing terms
• Condition of Sale
• Expenditures made immediately after purchase
• Market conditions
• Location
• Physical characteristics
• Economic characteristics
• Use/Zoning
• Non-Reality Components of Value

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4.5.2 Adjustment to Comparable Sales
Data
It is the most demanding step in sales comparison approach since the
adjustments made should first and foremost be related to the market.
The main objective of adjustment is to change the comparable sales data in to

an approximation of the subject property.
If the comparable sales are inferior to the subject property with respect to the
elements of comparison, the comparable sales data will be adjusted to upward.
If the comparable sales are superior to the subject property, the
comparable sales price must be adjusted downward.
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Cont.
The adjustment may be applied in various ways based on how the relationship
between the properties under consideration is expressed in the market.
Appraisers commonly use three types of quantitative adjustments.
These are:
Lump sum/monetary (dollar),
Percentage and
Units of comparison
Lump sum/monetary adjustment

Adjustments can be calculated in monetary (money) amounts.
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Cont.
In this type of adjustment a specific monetary amount is used to adjust each sale
for any property difference.
The comparable sales can be adjusted by adding or deducting some amount

from the price of each comparable sale so as to approximate them to the
subject property.
For example, let us consider that we have a comparable property which has a
garage at the basement. However, the subject property doesn’t have a garage.
Determine the adjusted sales price of the comparable with a sales price of
300,000 birr if the garage increases the sales price of the comparable property
by 20,000
144
birr.

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Cont.
 Sales Price ---------------------------------------------300,000.00

Less: Adjustment for garage -----------------------20,000.00
Equals: Adjusted price of the comparable ------- 280,000.00 birr
Percentage adjustments
Adjustments for differences between a comparable property and a
subject property are frequently expressed in percentages.
Percentage adjustments are often used to reflect differences in market
conditions and location.
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Cont.
For example, the data may indicate that market conditions have resulted in a
10% increase in overall property prices during the past year.
Similarly, an appraiser may analyze market data and conclude that properties
in one location are sold for prices approximately 10% higher than the prices
of similar properties in another location
These percentages are often converted into monetary amounts that are then
added to or subtracted from the price of the comparable so that it can be
approximated to the subject property.
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Cont.
If the comparables are found to be similar to the subject, adjustment
is not necessary.
For example, in a rapidly rising market a comparable with a sale date that is
three months earlier than the date of valuation might be adjusted by 3% to
show a 1% increase in market price per month. In other words, the sales price
will be increased by 3% with in three months. If the comparable property is
sold for 500,000 birr, the adjusted sales price after three months will be:
Sales Price ---------------------------------------- 500,000.00

Plus:Time adjustment ---------------------------- 15,000.00
Equals: Adjusted Price --------------------------- 515,000.00 birr
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Cont.
Units of comparison adjustment
In this type of adjustment an appraiser has to first select an important property unit
such as square foot of building area and analyze that sales on this basis.
Here, an appraiser would convert the sale from price to price per
square foot.
Example:
Sales price per

Sale Sales price Building square foot
in birr area
(square
foot)
1 350,000 1200 291.7
2 375,000 1500 250
3 320,000 1100 290.9
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Cont.
Qualitative Analysis
After an appraiser has applied quantitative adjustments to the comparables or
when quantitative adjustments cannot be made, the following forms of
qualitative analysis can be applied:
Relative comparison analysis – it involves narrative discussion of the
positive or negative attributes of comparables. E.g.This comparable is
inferior to the subject, the subject would sell for a higher price.
Ranking analysis - the comparable sales are ranked in descending or
ascending order.Then the appraiser can analyze each sale to determine the
relative position of the subject property in the array.
Personal interviews – interviewing market participants will often give
appraisers a good indication of the value of the property or what it is not
worth.

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Sequence of Adjustment
 According to the practice recommended by the Appraisal Institute of US, appraisers have to make adjustment of sales price of
comparable properties in the sequences indicated below.
 Sales price of comparable property
+/- property rights conveyed

+/- condition of sale
+/- financing terms
= Normal sales price
+/- adjustment immediately after purchase
+/- Market conditions
= Market adjusted normal sales price
+/- Location
+/- Physical characteristics
+/- Economic characteristics
+/- Legal characteristics
+/- Use
+/- Non-reality component
88 = Final adjusted sales price of comparable

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4.6 Methods Used in Sales Comparison Approach
Appraisers can use the three methods in sales comparison approach
in order to estimate the value of the subject property.
These are:
A. Area method
B. Assessment value method
C. Net capitalization method
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A. Area Method
To estimate the value of the subject property in this method, the appraiser should
have the sales price and the area of the comparable properties to find out the sales
price per unit area of comparable properties.
Sales price
Sales price per unit area of comparables 
Area
Sales price of comparables

Value of the subject property  ( )( Area of the subject property)
Area of comparables
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Example how to apply the comparative Method:
• Value the market rent of an industrial unit with a gross internal floor
area of 3,250 sq.m.
• A nearby and very similar comparable building, measuring 4,100 sq.m.,
has recently been let on the open market for £287,000 per annum.
Comparable = £287,000/4,100
= £70 psm (per square metre)
• Thus estimated market rent value of subject property

= £70 × 3,250 sq.m.
= £227,500 per annum

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Cont.
 The exact choice of this estimated market value of the subject property depends on how the
subject property compares with the comparable properties.

It will be the mean value if the subject property is as good as the comparable properties.
It will be the maximum value if the subject property is better than the comparative
properties.
It will be the minimum values if the subject property is slightly inferior to the
comparable properties.

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Cont.
B. Assessment Value Method

In this method an appraiser is required to identify the ratio of the sales price to
assessed value of comparable properties
Sales price of comparables
PAV 
Assessed of value of comparables
Value of the subject property= (Assessed value of the subject x PAV of

comparables)
96

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Cont.
C. Net Capitalization Method
In this method, the appraiser is required to determine the
Net operating income (NOI) and
Yield of comparable properties
NOI of comparable properties

Yield Rate  Sales price of comparables
Estimated NOI of the subject property

Estimated value of the subject property  Yield rate
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Unit 5
Cost Approach
5.1 Introduction
The cost approach is one of the three basic valuation methods in real estate
appraisal.
The cost approach is a set of procedures through which a value indication is
derived for a property by estimating the current cost to construct a
reproduction of or replacement for the existing structure plus any profit or
incentive, deducting depreciation from the total cost and adding the estimated
sit/land value.
Under this approach the property is valued as a function of what it would cost
to buy the157land and construct the buildings.

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Cont.
There would also be allowances(adjustments) made for depreciation.

This approach historically has been known as the summation approach.
The fundamental premise of the cost approach is based on the principle of
substitution.
Cost approach to reach to the market value is unique compared to the other
two approaches
The procedure for the development of market value of the improvements is
the conversion of the “cost to construct” figure to market value figure.
Cost is not necessarily or automatically equivalent to market value.
Thus, the process of making such conversion requires care, caution and
better skill.
Cost Approach Relation to Appraisal Principles
The principles on which the cost approach is based on
1. Substitution
This states that when several similar commodities, goods or services are
available in the market, the one with the lowest price attracts the greatest
demand.
According to this principle, a buyer will not pay more for one property than for
another that is equally desirable in the property market.
This provides the rational for developing the replacement cost of the subject
property rather than the reproduction cost.
In many situations, however, the time required to construct new buildings cost
slightly higher price.
2. Supply and Demand
Shifts in demand and supply cause prices to increase or decrease. Thus, one
property may have different price over time.
If costs do not shift in proportion to price changes, the construction of
buildings will be more or less profitable and the value of existing buildings
will increase or decrease commensurately.
3. Contribution
The principle of contribution states that the cost of an improvement must be
in proportion to the value of the site.
 The optimum ratio of land value to building value can and will vary from
market to market, so it is important for appraisers to research the most
common ratio in any given market.
160
4. Highest and Best Uses
 It can be more significant in the cost approach.
 In the sales comparison and income capitalization approaches, losses due to
 Improper improvements on the site,
 Over improvement,
 Other highest and best use problems are often reflected in the market data for comparable
properties, and
these lessen have to be identified and adjusted for in the cost approach.
5. Stabilization
 The term Stabilization describes the point at which a property reaches a profitable and sustainable
level of occupancy.
 When income-producing properties are built new or substantially remodeled, occupancy levels will
be much less than 100%.
 In other words, a buyer for an empty building will factor in the cost (Construction, broker fees, debt
service, taxes, etc.) to bring the building up to stabilized occupancy.
 That cost should be accounted for in the calculation of reproduction cost in the cost
approach.
6.Externalities
• An externality such as inflation may sometimes increase
material and labor costs
• Externalities can be temporary and may work in positive
and negative directions.
Assumptions, Applicability and Limitations of Cost Approach
Assumptions
The cost approach is based on the assumptions of the principle of substitution.
It is also based on the assumption that the replacement cost normally sets the
upper limit of value provided that the improvement is new and represents the
highest and best use of land.
It is further based on the assumption that a newly constructed building has more
advantages over existing buildings.
The cost approach assumes that cost (including entrepreneurial profit) equals
value.
210
CONT.
Applicability
The cost approach is applied to estimate depreciation for income taxes.
The cost approach is more applicable to appraisal problems where market
data is lacking for the income or comparison approach.
Church, mosques, museums, public buildings and other special purposes
buildings are usually appraised using the cost approach
The cost approach is more applicable and reliable for new buildings than
for old buildings
Cont.
Limitations
The cost approach is limited to the situation that:
 The property appraised should be new so that this approach can give a true
indication of value and
 The estimate of depreciation should be accurate
Difficulty
The cost approach is difficult:
 In deciding whether cost and market value are likely to be approximately
equal.
In calculating depreciation, particularly physical and functional depreciation.
Procedure/Steps in Cost Approach
An appraiser who wants to estimate the value of the subject property using
the cost approach should follow the following procedure
1.Estimates the value of land as though vacant and available to be
developed to its highest and best use.
2.Determine which cost is most applicable to the assignment:
reproduction cost or replacement cost
3.Estimate the direct and indirect costs of improvements as of the effective
date of the appraisal.
4.Estimate an appropriate entrepreneurial profit
5.Add the estimated direct costs, indirect costs and the entrepreneurial profit
and there by determine the total cost of improvements
215
CONT.
6.Estimate the amount of depreciation in the structure and allocate it among the
three major categories:
Physical deterioration
Functional obsolescence
External obsolescence
7. Subtract estimated depreciation from total cost of improvement to obtain an
estimate of depreciated cost of improvement.
8.Estimate site value improvement
9.Add the land value and site value improvement to the total depreciated cost of
improvements to arrive at the indicated value of the property.
10.Adjust the indicated value of the property for any personal property (such
as furniture, fixture, and equipment) or intangible asset value that my be
included to the cost estimate.
CONT
The theoretical base for the cost approach is reproduction cost, but replacement
cost is commonly used because it may be easier to obtain and reduce the
complexity of depreciation analysis.
An important difference must be made between reproduction cost and
replacement cost.
Reproduction cost is the estimated cost to construct, as of the effective date
appraisal, an exact duplicate or replica of the building being appraised in so
far as possible using the same materials, standards, design, lay out, quality of
workmanship, embodying all the deficiencies, super adequacies and
obsolescence of the subject building.
 Replacement cost is the estimated cost to construct, as of the effective date
of appraisal, a building with utility equivalent to the building being appraised
using contemporary materials, current construction standards, design and
layout. 218
CONT.
• The decision to use reproduction or replacement cost is

usually determined by
• The age of the structure,
• Its uniqueness,
• Any difference between its intended use at the time of construction and
 Its current highest and best use.
In theory, the use of reproduction cost and replacement cost

should yield similar value indication, but in practice both
cost estimates and depreciation estimates will be different
Cost estimates
Appraisers must consider direct (hard) costs and indirect (soft) costs in order
to develop cost estimates of a building.
Both types of costs are essential to a reliable cost estimates.
Direct costs:
Direct construction costs include the costs of material and labor as well as
the contractors profit required to construct the improvement on the effective
date of appraisal.
CONT.
Direct costs include costs of :
Building permits
Materials, products, and equipment
Labor used in construction
Equipment used in construction
Security used during construction
Constructors shake and temporary fence
Material storage facilities
Power line installation and utility costs
Contractor's profit and overhead including job supervision,
coordination and management, workers compensation, fire, liability
Indirect Costs
Indirect costs are expenditures or allowances that are necessary for
construction but are not part of the construction contract.
Indirect costs include costs of :
 Architectural and engineering fees for plans, plan checks, surveys to
establish building lines and grades, and environmental studies
Appraisal, consulting, accounting and legal fees
The cost of carrying out the investment in land and contract payments
during construction (e.g interests paid on construction loans)
The cost of carrying the investment in the property after construction is
complete but before stabilization is achieved.
Supplemental capital investment in tenant improvement and leasing
commission
CONT.
In the case of income producing properties, the profit realized depends on the
entrepreneur’s ability to obtain the proper tenant mix and negotiate leases.
In analyzing the components of the reward and compensation received (or
anticipated) by an entrepreneur, the appraiser has to distinguish between the
concepts of
Project profit is the total amount of reward for entrepreneurial coordination
and risk.
Entrepreneurial profit refers to the portion of the project profit attributable
to the efforts of the entrepreneur distinct from the effort of the developer..
Developer’s profit represents compensation for the time, energy and
expertise of an individual other than the entrepreneur.
Contractor’s profit is essentially a portion of the project’s overhead and
included in the fee the contractor charges and would there fore be included
in the direct cost.
Depreciation(Devaluation)
Depreciation is the difference between what an improvement costs and the
value of the improvement on the effective date of appraisal.
Depreciation can be broken down into three types:
Physical deterioration(worsening)
Functional obsolescence(uselessness)
230
Building Cost Estimates
To apply the cost approach to value, an appraiser must prepare an estimate of
the cost of the improvements as of the effective date of appraisal.
Such an estimate can be prepared by an appraiser who understands
Construction plans,
Specifications,
Materials,
Techniques and
Can access a variety of data sources or computer programs
available for this purpose.
Alternatively,the work can be done with theassistance of the expert
cost estimators.
175
Sources of data for cost
Construction contracts for buildings similar to the building being appraised
provide a primary source of comparable cost data.
There are four primary methods used by appraisers to estimate the
construction cost.
These are:
Comparative (Square foot) method
Quantity survey method
Unit- in- place method
Trended historical cost (index) method
176
Comparative (Square foot) method
 The most commonly used method of estimating building cost is the comparative method.
 Under this method, the cost of building is determined by some measure of its size usually its
square footage.
 The cost per square foot can be found from similar developments in the area or from
published sources.
 The comparative method assumes that there are numerous similar buildings that can be
grouped by
Design,
Type and
Quality of construction
 Replacement cost factors can be obtained by developing average unit costs from known
construction costs of new buildings in each group.
CONT
The appraiser can identify costs of similar structures adjusting those costs for
differences in marketing conditions, location and physical characteristics in
comparison to the subject property.
It combines all costs for a particular type and quality of structure into one
value as a cost per square foot.
It produces a value based on the floor area of the structure.
Contractors overhead and profit may be either included in the cost estimate per
unit area or computed separately.
Indirect costs and entrepreneurial profit are usually compute
separately.
239
CONT.
Unit cost varies, all else being equal, with building size. Unit cost decreases, as
building increases in area.
This is reflected with the fact that
Plumbing,
Heating system,
Doors,
Windows, and
Similar items do not necessarily cost proportionately more in a large
house than in a small one.
If a similar cost spreads over a large area, the unit cost is obviously less.
This method is relatively less complicated, widely used and practical.
CONT.
If the comparable sale has one bathroom more than the subject
property, that cost should be subtracted from the sales price of the
comparable property to get a more accurate figure.
Consider the following example:
An appraiser is using the cost approach to confirm the value received
through direct sales comparison. The appraiser has got three new
homes recently sold in the area to estimate the cost per square foot.
The lots are all valued at 50,000 birr and the cost of one bathroom is
estimated to be 4,000 birr.
CONT.
Subject Comparable Comparable Comparable
property sale 1 sale 2 sale 3
Square foot 1,550 1,400 1,550 1,650

home
Square foot lot 6,000 6,000 6,000 6,000
No of 2 3 3 2
bathroom
s
Selling price in 153,000 158,000 163,000
birr
Determine the cost per square foot of the three properties

based on the above given.
CONT.
Comparable Sale 1 Comparable Comparable
Sale 2 Sale 3
Sales price in br 153, 000 158,000 163,000

Less: Lot - 50,000 - 50,000 - 50,000
Less: one - 4,000 - 4,000 0
bathroom
Building value 99,000 104,000 113,000

in br
Divided by 1,400 1,550 1650

Sq.ft.
Cost/Sq.ft (99,000/1,400)= 70.71 67.09 br/sq.ft 68.48 br/sq.ft

br/sq.ft
182
CONT,
In our example, the subject property is close to comparable sale 2. Thus, it is
advisable to take 67.09 br/sq.ft. as the cost per unit square foot of the subject
property.
Based on this rate, the construction cost of the subject property would be 1,550
sq.ft X 67.09 br/sq.ft = 104,000 birr.
In some cases, it could become necessary to interpolate figures, meaning to
choose some figure between some comparable sales.
For example,
Suppose that the cost per square foot of a 1,600 sq.ft home is 72.5 birr and
that of a 1,800 sq.ft home is 71.5 birr. If you are asked to determine the cost
per sq.ft of a 1700 sq.ft home, 72 birr would be a reasonable estimate.
183
Quantity Survey Method
It is the most comprehensive and accurate method of estimating building cost,
which will more often be applied by a contractor or professional cost estimator
than appraiser.
A quantity reflects both the quantity and quality of all materials used in the
construction of improvements and all categories of labor required.
It is an item by item inventory of all costs, including contactors profit. It is the
most accurate method if it is done by the quantity surveyor.
184
CONT.
Unit cost are applied to those figures to arrive at a total cost estimate for
material and labor, then the contractor adds a margin for contingencies,
overhead and profit.
Appraisers are not routinelyused this method unless it is
specifically requested by the client.
Example: The following two tables summarize a general contractor’s cost

break down (direct and indirect costs) for an apartment building which has
149,000 birr site value. Determine the value of the property assuming that
the entrepreneurial profit is 15% of the sum of direct costs, indirect cost and
site value.
185
Building cost component Cost
Direct Cost
Foundation 23,000
Frame 191,000
Floor structure 223,000
Floor cover 96,000
Exterior walls 647,000
Interior walls 433,000
Electrical system 59,000
Electrical fixtures 28,000
HVAC 242,000
Roof structure 205,000
Ceilings 79,000
Painting 18,000
Plumbing system 65,000
On site improvements and landscaping 1,205,000

Permits and fees 290,000
186 Total direct costs 3,804,000
Indirect costs
Architectural/ engineering
services 304,000
Survey 8,000
Toxic assessment 5,000
Construction loan interest 188,954
Appraisals 16,000
Legal 25,000
Development consultants 148,000
Total indirect costs 694,954
187
CONT.
This table shows how to calculate the value of the property using quantity
survey method.
Total improvement costs
(direct costs plus indirect
costs) 4,498,954
Site value 149,000

(4,498,954 + 149,000) x 15%
Entrepreneurial profit (15%
of total improvement cost =
and site value) 697,193
Total improvement cost 4,498,954 + 697,193

new =
5,196,147
Total value indication by 5,196 ,147 + 149,000
188 the cost approach 5,345,147
Unit - in –Place Method
It is a simplification of the quantity survey method. It is also called the
segregated cost method.
It finds the sum of the cost of installed materials using convenient units of
measurement such as the cost to install foundation, roof, plumbing, wiring,
heating and exterior wall and etc
The cost of building each unit would be specified with the sum of the units
representing the total cost of each building.
This method is also very detailed next to quantity survey method and needs
sophisticated estimating skills
This method is especially suited for industrial buildings since they vary greatly
in size, shape, height.
.
CONT.
Example: Suppose that the floor and foundation of these buildings costs 8.25 birr per
sq.ft., the roof costs 16.5 birr per sq,ft., and the wall costs 275 birr per linear foot.
Notice that both the square building and the rectangular building have 10,000 sq.ft.
but the square building has only 400 linear feet for walls while the rectangular
building has 500 linear feet of walls. Consider how this would affect the construction
cost for each building.
Square building Rectangular Building
Floor @8.25 82,500 Floor 82,500

Roof @ 16.5 165,000 Roof 165,000
Walls (400 X275) 110,000 Walls (500X275) 137,500
Total cost 357,500 Total cost 385,000

190
CONT
Given these different costs, its effect on the cost per square foot becomes:
Square building Rectangular building

Total cost 357,500 Total cost 385,000
Sq.ft. 10,000 Sq.ft 10,000
Cost/sq.ft. 35.75 br/sq.ft Cost/sq.ft. 38.5 br/sq,ft
One advantage of the unit in place method is that it would automatically take into
account the shape of the building and its square footage.
Consider an example of a unit in place cost method.The subject property is
7000 sq.ft. warehouse measuring 70X100.
The following are the cost of various components.
191
. Building components Installation costs
Building permit 5,000 birr
Excavation: (2556 cubic yards @ 4.56 ) 11,655
Foundation: (7000 sq.ft @6.35) 44,450
Walls (340@325) 110,500
Roof structure: (7,000 sq.ft @16.75) 117,250
Roof covering: 8,500
Plumping pipe: (7,000 sq.ft @3.23) 22,610
Plumping fixtures: (11 fixtures @475) 5,225
Sewer hookup 3,500
Wiring and outlets (7000sq.ft @4.33) 30,310
Windows (27@125) 3,375
Heating (7,000 sq.ft @1.75) 12,250
Sprinkler (7,000 sq.ft. @) 2.07) 14,490
Miscellaneous costs 25,000
Total costs 414,115 birr
192
Trended Historical Cost(Index) Method
Cost index trending may be used to convert historical data into a current cost
estimate.
Cost indexes are published as part of a cost manual.
If the historical construction cost is known, a cost index can convert that cost
into an indication of cost new for the date of appraisal.
The index approach is used in a situation when the original construction of
the existing improvement is already known.
It is most commonly used in the case of unique buildings.
The further away the date of construction, the less accurate the estimate
will be.
CONT.
To trend the historical cost into current cost, the current cost index should be
divided by the historical cost index and the result should be multiplied by the
historical cost.
Example: Suppose the contract cost for constructing a building in January 1994
was 1,000,000 birr. The index for January 1994 is 285.1 and the current index is
327.3 as it is obtained from the cost manual. Determine the current cost of the
subject building using the trended historical cost or index method.
261
CONT.
The current cost of the subject building is:
(327.3/285.1) = 1.148
1.148 X 1,000,000 birr = 1,148,000 birr
In other words, a building that cost Birr 1,000,000 in 1994 would cost about Birr
1,148,000 today.
This method is the least accurate of any of the methods mentioned above to cost
estimation.
The historical cost of a property may be significantly higher or lower than its market
value at the time of construction.
As the time span between the initial construction and the date of value increases, the
trended historical cost method yields less reliable indicators of value.
262
Estimation of Depreciation
It involves estimating the replacement cost as new of the property and
decrease depreciation of the property.
In other words, once the replacement cost of the existing improvement
has been estimated, the next step is to subtract the depreciation from the
property.
196
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CONT.
In the cost approach, one of thedifficult task is estimating deprecation of
the property.
Depreciation may thought of as the difference between the present value of the
outmoded subject property and the present value of the, newly built, modern
property of equivalent utility.
Thus, in appraisal sense the term depreciation refers not to the decline in the
original value of the subject property, but rather to a measurement of the
extent to which the subject property is worth less than the new property.
197
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CONT.
There are a number of approaches by which depreciation either for

accounting or valuation purpose can be estimated.
The accounting approach to depreciation is quite different from the
appraisal approach.
The appraiser doesn’t use the accountants depreciation estimate in
valuation, since it is not market driven.
For instance, a method that is commonly used among accountants
is the straight-line or age life method.
198
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CONT.
By then end of the assets life, the value of the asset has been
depreciated to a typically nominal or zero salvage value.
Unlike the depreciated adopted for accounting purpose, the appraiser
is supposed to arrive at a value that represents the current market
value of the property.
Depreciation for appraisal purpose estimates the actual loss in
value incurred due to by the property in the market place.
199
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Causes of Depreciation
Appraisers group various forms of depreciation in to three categories.
A. Physical Deterioration
Physical deterioration is a loss in value due to use or forces of nature. It is
the most obvious cause of depreciation.
Buildings will ultimately wear out due to the physical forces of nature
working to destroy them .
268
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CONT.
Physical deterioration occurs to virtually all improvements as they age,
lowering their utility, and consequently reducing their value.
Examples of physical deterioration are
Peeling paint
Flood damage
Metal fatigue etc
Proper maintenance can slow a building’s rate of
physical
deterioration.
Physical deterioration can be classified as
Curable and
Incurable
269 deterioration
11/23/2023 abay. (LaSu) 201

CONT.
B. Functional Obsolescence
A property’s functional utility reflects its overall usefulness or desirability,
i.e., its ability to satisfy the wants and needs of the market place.
Functional obsolescence isa loss in utility and value due to
a
reduction in the desirability of the property.
273
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CONT.
It can be caused by the factors inherent to the property.
This form of obsolescence may be attributable to
Changes in tastes and preferences with in the market place
Change in building techniques or technology
Poor original design that is deficient or excessive when
compared to the current market standards
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CONT.
The following are the factors that could lead to functional obsolescence.
1. Excessive floor space:
2. Inappropriate building layout, and disjointed production flow:
3. Excessive operating costs:
4. Excessive height
5. Excessive or superior construction:
6. Inferior materials or construction:
7. Change in property use:
8. Bay size (column spacing)
9. Poor lightning or poor installation of other services
204
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CONT,
C. External Obsolescence
External obsolescence sometimes called as economic obsolescence is a loss
in value caused by the negative influences of the subject property.
It can also be caused by regional factors,such as problems experienced by
local industries.
In addition to these, it can be caused by national factors such as when a
recession or depression affects property value.
External obsolescence usually affects the whole classes of properties in an
area, rather than a single property.
205
11/23/2023
abay. (LaSu) 205

CONT.
The following are the factors that could lead to external obsolescence.
 Technological change:
 Change in attractiveness of the location
 Change in government restrictions and regulations:.
 Physical site restriction:
 Change in sources of supply:
279
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Methods of Estimating Depreciation
Accrued depreciation is depreciation which has already occurred up to the
date of valuation.
Where as remainder depreciation is depreciation that will occur in the
future.
Accrued depreciation may be either curable or incurable.
The measure between curable and incurable is economic feasibility.
Before examining depreciation in detail, let us review the following
concepts.
280
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CONT.
Recognizing depreciation
There are three types of knowledge that will assist the assessors in establishing
depreciation.
1. Knowledge about the physical nature of the property:
 Type of construction
 Condition of improvements
 Nature of soil condition
 Site configuration and building layout
2. Knowledge about the operation of the property:

 Functionality of the property
 Financial health of the business
 Use and utility of the property
28
11/23/2023 abay. (LaSu) 208

CONT.
3. Knowledge about economic conditions:
General economic conditions
Economic conditions with respect to particular property
Information gathering
A site inspectionis necessaryto determine the condition and functionality of the
property.
Discussion with property owner/operator are the best resource for information about
the functionality and utility of a property.
Appraisers can make market research to get information.
Information about general economic conditions can be determined by financial
statistics that can be found in local newspapers or
government publications
.
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CONT.
Age and Life Concepts
In real property valuation, the overall concept of the depreciation rely on the
age- life relationship used to determine both total depreciation and physical
deterioration of components from improvements.
The following age life concepts used for market extraction and age-life
method of estimating depreciation.
 Effective age
 Economic life
 Remaining economic life
11/23/2023 abay. (LaSu) 210

CONT.
Principal methods of estimating depreciation
A. Market extraction method
B. Age - life method
C. Breakdown method
Most appraisers apply the market extraction or age-life method.
They are applied to the whole property, and are easier to understand and
apply.
Both methods assume lump sum depreciation(total depreciation)from all
causes, the elements of depreciation are implicit.
They rely primarily on the appraiser’s estimate of effective age and
remaining economics life.
11/23/2023 abay. (LaSu) 211

CONT.
Breakdown method is more comprehensive that identifies specific elements of

depreciation and treats each element separately.
It independently treats each component of total depreciation:
 Physical deterioration
 Functional obsolescence
 External obsolescence
A. Market Extraction Method

 The market extraction method (also called the market or comparable sales
data method) is the only method that uses comparable sales data to estimate
depreciation.

11/23/2023 abay. (LaSu) 212

CONT.
This method requires
Sales price,
Site value and
Accurate estimate of cost of new properties that are highly
comparable to the subject property,
Cost of improvement new of the subject.
 The market extraction method includes the following steps:
1. Identify and verify sales of similar/comparable properties that appear to
have incurred a comparable amount of depreciation
2. Adjust the comparable sales, if necessary, for any difference related to
property rights conveyed, financing or non-reality property items included
in the sales price
11/23/2023 abay. (LaSu) 213

CONT.
3.Subtract the estimated value of land/site as of the sale date from each
comparable sale in order to arrive at an estimate of the residual, depreciated
value of improvement
4.Estimate the cost new of improvements for each comparable at the time of
sale. The cost estimates should have the same basis: reproduction or
replacement cost.
5.Subtract the depreciated value of improvement (item 3) from cost new (item 4)
to arrive at monetary estimate of total depreciation for each comparable sale.
6.Convert each monetary estimate of total depreciation into percentages by
dividing each estimate of total depreciation by the cost new of each
comparable sale.This rate is applied to the subject property’s cost to derive
the estimate the subject’s total depreciation.
292
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CONT
Example 1:
Suppose that a comparable property was sold for 350,000 birr and the site
value appropriate for this comparable was estimated at 100,000 birr. The cost to
build the property new today is estimated at 300,000 birr. The effective age of
the property is 10 years old.
Estimate the total depreciation of the subject property which has an
effective age of 15 years old and its cost of improvement is 280,000 birr at the
date of appraisal based on this information.
215
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CONT.
Sales price of the comparable --------------------------- 350,000
Less: Estimated site/land value ------------------------ 100,000
Depreciated cost of improvement ----------------------- 250,000
Cost of improvement new ------------------------------- 300,000
Less: Depreciated cost of improvement ---------------- 250,000
Total depreciation ----------------------------------- ------ 50,000
Rate of depreciation--------(Total depreciation ÷ Cost of improvement) X 100
============50,000 ÷ 300,000)X 100= 16.7 %
Annual depreciation of comparable is 16.7% ÷ 10= 1.67 %
216
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CONT.
Since the effective age of the building is 15 years, the depreciation
rate is
1.67% X 15 years= 25.05 %
The total depreciation of the subject property is
0.251 X 280,000 birr= 70,280 birr
217
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CONT.
Exercise:
Suppose that the sales price of a comparable property is 450,000 birr
and its estimated site value is 20 % of its sales price. The cost of
improvement new of this property is estimated at 480,000 birr and its
effective age is 15 years. Estimate the total depreciation of the subject
property which has cost of improvement new of 420,000 birr and an
effective age of 20 years.
39
11/23/2023 abay. (LaSu) 218

• Sales price of the comparable --------------------------- 450,000
• Less: Estimated site/land value ------------------------ 90,000
• Depreciated cost of improvement ----------------------- 360,000
• Cost of improvement new ------------------------------- 480,000
• Less: Depreciated cost of improvement ---------------- 360,000
• Total depreciation ----------------------------------- ------ 120,000
• Rate ---------------(Total depreciation ÷ Cost of improvement) X 100
(120,000 ÷ 480,000)X 100 = 25 %
• Annual depreciation of comparable is
25% ÷ 15 = 1.6666 %
1.666 * 20 = 33.33%
0.33.33 * 420,000 = 139. 986 birr

219
valuation 2022
B. Age - Life Method
The age-life method is a quick and easy method to apply in estimating
building’s depreciated value.
Effective age and economic life of the property are the primary concepts
used by an appraiser in measuring depreciation using age- life method.
In this method, total depreciation is estimated by calculating the ratio of
effective age of the property to its economic life expectancy and apply
this ratio to the property’s total cost.
Effective age X Total cost of the property

Depreciation = Total Economic life
301
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CONT.
This method is applied in the following steps:
1. Identify anticipated total economic life of similar structures in the market area and
estimate effective age of the subject building.
2. Divide the estimated effective age of the subject property by the anticipated
economics life, apply the ratio to the subject cost to estimate total depreciation of the
subject.
3. Subtract the estimate of total depreciation from the cost of the subject improvement to
arrive at the improvement’s contribution to property value.
Example 1:
Suppose that a residence property has an actual age of 15 years, an estimated effective age
of 10 years and a remaining economic life of 40 years. The replacement cost new of the
property is 500,000 birr.
302
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CONT.
Estimate total depreciation of the property and its depreciated replacement cost based on the
above given.
Given:
Actual age = 15 years
Effective age = 10 years
Remaining economic life = 40 years
Total replacement cost of improvement = 500,000 birr
Total economic life = 10 years + 40 years = 50 years
Total depreciation = (10/50) X 500,000 birr = 100,000 birr
Depreciated replacement cost = replacement cost minus total depreciation.
Depreciated replacement cost = 500,000 - 100,000 birr = 400,000 birr
11/23/2023 abay. (LaSu) 222

CONT.
Applicability
• The age-life method is simple, and easy to understand. It allows an appraiser to determine total
depreciation.
 Inherent in this method is the assumption that every building depreciates on a straight
line basis (equal percentage of depreciation every year).
Limitation
 However, it has the following limitations.
This method assumes that every building depreciates on a straight line basis over the course
of its economic life. The straight line pattern of depreciation is only an approximation.
This method, like the market extraction method, doesn’t segregate depreciation into its
various components and difficult to apply.
It doesn’t recognize the difference between short lived and long lived items of physical
deterioration.
309
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C. Breakdown Method
It is the most comprehensive and detailed method of estimating depreciation.
It breaks down total depreciation into three categories: physical,
functional and external, and then breaks down each of them further into
subheadings:
Curable – deferred maintenance
Incurable – short lived
Incurable – long lived
310
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CONT.
Curable – deficiency
Curable – modernization
Curable – super adequacy that is economically feasible to cure
Incurable – deficiency that is not economically feasible to cure
Incurable- super adequacy that is not economically feasible to cure
Locational
Economic
 Deficiency is the a missing component in the subject property type from which the
standard needs.
 Super adequacy refers to a component of the building that exceeds the standard
normally expected in the market place
311 .
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Estimating physical depreciation
Curable Physical Deterioration
It consists of items in need of repair or
replacement at the time of valuation.
Leaky roof, peeling paint, broken or stuck window, a non-
working air conditioner, faulty plumbing, interior
decorating, pest control etc are examples of deferred
maintenance.
There are two tests for determining whether physical
deterioration is curable or not.
The appraiser must determine whether the cost to cure an item will result
in added value equal to or greater than the cost to
Even when the cost to cure exceeds the added value, if curing the item will
312
allow the entire property to maintain its value, that item is generally
considered curable.
11/23/2023 abay. (LaSu) 226
CONT.
Procedure:
The procedure for estimating curable physical deterioration is summarized as
follows:
1. Identify each item of deferred maintenance during the time of property
inspection.
2. Estimate the cost to cure or correct each itemof deferred
maintenance.
3. Add each respective estimate from step 2 to arrive at an indication of total
curable physical deterioration for the improvements.
227
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CONT.
Example 1:
During physical inspection of the subject property, you notice a 10 years old single family
residence needs repair of a broken window pane, painting of all exterior wood and trim,
and replacement of several wood boards on the exterior of the home. From you cost files
and conversations with several building contactors, you estimate the cost to repair the
window pane at 75 birr, the cost to paint the homes exterior at 1,700 birr and the cost to
replace the deteriorated wood boards at 225 birr.
Estimateof total curable physical deterioration, or deferred
maintenance.
Total curable physical deterioration = 75 br + 1,700 br + 225br = 2000 br
228
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CONT.
Example 2:
1. A property has a garage door with effective age of 12 years old. Its replacement cost is
1,900 birr. Since the stormy weather comes from the North West, this door will have an
economic life of 15 years if it faces the west and 25 years if it faces the east. The door
faces east.What is the amount left in this item?
Solution:
Garage door replacement cost ----------------- 1,900
Less: Depreciation (12/25)x 1900----------------912
Amount left -------------------------------------- 988 birr
229
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CONT.
Example 3: A store building has a remaining economic life of 30 years and an effective
age of 20 years. Present reproduction cost of the structure is 230,000 birr. The roof is
75% deteriorated. A new roof will cost 10,000 birr. The air conditioning and heating
systems are 40% depreciated. Their installed cost new is 8,000 birr. What is the total
amount of physical deterioration?
Solution:
Depreciation on roof (0.75 X10,000 br) = 7,500
Depreciation on air conditioning & heating (0.4x8,000) = 3,200
Depreciation on the rest of the building ( 20/50)x(230,000-10,000-8,000) = 84,800
Total physical deterioration -------------------------- ------- 95,500 birr
230
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Incurable physical deterioration
Incurable physical deterioration is the physical deterioration that is not
economical to repair as of the date of appraisal, i.e., the cost to cure the defect
exceeds the added value of the repair.
It can be classified as short-lived and long-lived physical
deterioration.
Incurable physical deterioration, short-lived

The procedure of estimating incurable physical deterioration of a short-lived
items is summarized as follows.
231
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CONT.
1. Estimate the effective age of short lived component. In most circumstances
the effective age of short lived component will be the same or very similar
to its actual age.
2. Estimate the total physical life of the short lived component.
3. Divide the component’s effective age by its estimated physical life to arrive
at an estimate of straight line physical deterioration for the short-lived
component.
4. Estimate the reproduction or replacement cost new the short-lived
component as of the date of the appraisal.
232
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CONT.
5.Multiply the straight line physical deterioration estimate of each short-lived
component by the respective components cost new estimate
6.Add the depreciation estimate for each short-lived component of a structure
to arrive at an indication of the total physical deterioration of the incurable
short lived components.
Incurable physical deterioration, long-lived

• The procedure of estimating incurable physical deterioration of a long-lived
items is summarized as follows.
233
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CONT.
1. Estimate the reproduction or replacement cost new of the entire building
structure.
2. Drive the estimated reproduction or replacement cost new of the long-lived
components as of the date of the appraisal by subtracting the cost new of
curable physical components and the incurable short-lived components from
the total cost new of the entire building structure.
3. Estimate effective age of the entire building structure.
4. Estimate the total economic life of the entire building structure.
5. Divide the structure’s effective age by its estimated total economic life to
arrive at an estimated percentage straight line physical deterioration for the
long-lived components.
234
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CONT.
6. Multiply the straight line physical deterioration estimate for the long-lived
components by the long-lived components cost new estimate to arrive at the
indicated amount of total physical deterioration attributable to the long-lived
components.
235
11/23/2023 abay. (LaSu)

Unit 6
Income Capitalization
Approach
6.1 Introduction
• Income capitalization approach is clear that property owners who have
income generating property anticipate that they will receive cash flows from
the property in the form of income from rental operations and price
appreciation.
• The value of the property in this approach is, therefore, a function of the
income stream that is expected to produce.
• In the income capitalization approach, an appraiser
• First estimates the periodic income obtained from the property in the
future,
• Then convert the income forecast into present value.
 35
CONT…
 The process of converting periodic income into an indication
of a present value is referred to as income capitalization.
 The principle of anticipation is fundamental to this approach.
 It is the primary theoretical base for income approach.
 This method of valuation relates value to two things
 The periodic rent that a property can be expected to earn
 Reversion or resale when the property is resold.
359
6.2 Assumption, Applications and
Limitations
Applications
• The income capitalization approach is more suitable for types of properties
purchased and held for the purpose of producing income.
• It is also the preferred approach for the appraisal of land where reliable
sales data for comparable properties are not available.
Limitations
• This approach is limited
 When the income estimates are weak
 When sales data are not available to extract capitalization rate
 When buyers consider other issues more than the property’s income
potential
360
CONT.
Assumption
• There are three fundamental assumptions for the income
approach.
These are:
• Value is a function of income
• Value depends on the amount, duration and risk of the income
stream
• Future income is less valuable than present income
239
6.3 Income Approach Relation to Appraisal Principles
Anticipation
• Anticipation is the perception that value is created by the
expectation of benefits to be derived in the future.
• This principle states that all income capitalization methods,
techniques and procedures try to anticipate future benefits to
estimate their present value.
• Investors are anticipating the future income stream from property in
their buying decisions.
• The principle of anticipation is fundamental to income capitalization
approach.
Change
• It is the result of the cause and effect relationship among the forces that
influence real property value.
• Change is inevitable though, at times, it may be difficult to identify.
• The expectations of investors concerning changes in income, expense
levels and property values must be considered by the appraiser.
• The principle of change is related to the principle of anticipation and can
affect the prediction of future benefits.
• Change may be gradual or rapid.
366
Supply and Demand
• The principles of demand and supply are important in anticipating future
benefits and estimating rates of return in income capitalization approach.
• Both income and rate of return are determined by market interaction
(buyers and sellers; tenants and landlords).
• If there are competing properties in the market, the rent charged by one
owner may not be as such different from rents charged by other owners of
the competing properties.
• According to this principle, the existence of excess demand results in an
increase in rent.
 Thissituation reduces vacancy rate
 The value of the property may rise until supply satisfies demand
CONT.
 On the other hand, if supply is greater than demand, there will be a decrease in
rent for a property.
 As a result,
 Occupancy rate shall be decreased
 Vacancy rate will be increased.
 Thus, appraisers should observe demand (both existing and forecasted) and
supply of a property so as to anticipate future income and estimate rate of
return.
Substitution
• The prices, rents and rates of return of properties tend to be set by the
prevailing(current) prices, rents and rates of return for equally desirable
substitute properties.
368
Balance
• Value is enhanced by a reasonable balance of types and locations of
income producing properties.
• According to this principle the highest market value will be realized when
the size and type of improvements are proportional to each other and as
well as to the land.
Contribution
• This principle states that a value of a component of property depends upon
its contribution to the whole.
• With income producing properties, the value of a component can be
measured by the amount it contributes to the net operating income
369 .
Externality
• The principle of externalities states that factors external to a
property can have positive or negative impact on its value.
• According to this principle economies outside a property have a positive
effect on its value while diseconomies outside a property have a negative
effect on its value.
• Because real estate is immobile, it is affected by external influences
more strongly than other goods.
• A property’s income generating capacity may be affected by external
factors.
370
The procedure of Income
capitalization
Research the income and expense data of the subject property and comparable
properties.
1. Estimate the potential gross income (PGI) of the subject property by summing
the rental income and other potential incomes.
2.Estimate vacancy and collection loss which is an allowance for reduction in
potential gross income attributable to vacancies, tenant turnover, and non
payment of rent.
• It is also referred to as vacancy and credit loss or vacancy and contingency
loss
CONT…
3. Deduct vacancy and collection loss form potential gross income and there by
determine effective gross income (EGI).
4. Estimate the total operating expenses of the subject property by adding

 Fixed expenses
 Variable expenses and
 Replacement allowance
5. Subtract the estimated total operating expenses from the estimated
effective gross income and arrive at net operating income (NOI) of the
subject property
6. Apply one of the two methods (direct capitalization or yield capitalization)

of income capitalization to generate an estimated value of the subject
property.
248
6.4 Terminologies used in Income
Approach
• There are different specialized terminologies used in income capitalization
approach than other approaches.
Lease
• Lease is a contract between a property owner (lessor) and a tenant (lessee)
that transfers exclusive use and possession of space to the tenant.
• In other words, lease is a written document in which the rights to use and
occupy land or structures are transferred by the owner to another party for a
specified period of time in return for a specified rent.
375
CONT..
A valid and enforceable lease has to contain the following elements:
1. The names of the landlord and tenant
2. An adequate description of leased property
3. An agreement to transfer possession of the property from the landlord to
the tenant
4. The start and end date of the agreement
5. Description of rental payment
6. The agreement has to be in written form
7. The agreement must be signed by both parties
376
CONT..
 Lease income is the basis of most real estate valuation using the income capitalization
approach.
 Thus, an appraiser commences the income capitalization approach through understanding
all existing and proposed leases that shall be applied to the subject property.
 An agreement between the lessor and the lessee on operating expenses has an effect on
income of the property.
 Lease is divided into the following types.
A. Flat rental lease
B. Variable rental lease
C. Step-up or step-down rental lease (graduated lease)
D. Revaluation lease
E. Percentage lease
377
Flat Rental Lease
• Flat rental lease means a lease with a specified level of rent that continues
throughout the lease term.
• It specifies a level of rent that continues throughout the duration of the
lease. For instance, a five year office lease might specify a fixed rental rate
of 100 birr per square meter per year.
• Flat rental lease is usual and suitable form of lease in a stable economy.
This type of arrangement is likely to be observed in short term lease.
378
Variable Rental (index) lease
• It is a type of lease that provides for periodic rent adjustments.
• It is quite common particularly when an owner anticipates periodic
changes in rent.
• This type of lease may specify periodic percentage change or the change
may be tied to specific index such as nationally published index like
consumer price index.
• This type of lease is referred to as index lease.
Graduated Rental Lease

• It is a type of lease that provides for a certain rent for an initial period,
followed by an increase or decrease in rent over states period.
379
CONT…
• This type of lease put a pre-specified increases or decreases in the amount of
rent.
• The pre-specified rent increases are referred to as “step-ups”. However, the
pre-specified rent decreases are referred to as “step-downs”.
• For example, a first five year office lease might be specified as a rental rate
of 100 birr per square meter per year, increasing by a 5 birr per square meter
each year for the remaining four years of lease.
254
Revaluation Lease
• This type of lease may have periodic rent adjustments based on revaluation
of market rent under the prevailing market conditions.
• When the parties to a lease cannot agree on rent, revaluation through
appraisal or arbitration may be stipulated in the lease.
Percentage Lease
• In this case, some or all of the rent charged is based on a specified
percentage of the volume of business, productivity, or use achieved by the
tenant.
255
RENT
• The income generated by investment properties includes primarily of rent.
• There are various types of rent that have an effect on the amount of
income that the property will generate.
• The most commonly used are:
a) Market rent
b) Contract rent
c) Effective rent
d) Excess rent
e) Deficit rent
256
Market Rent
• Market Rent is the rental income which a property would most probably
command in the open market.
• Market rent is established by the current rents being paid and asked for
comparable properties as of the appraisal date.
• Market rent is sometimes referred to as economic rent.
Contract Rent
• Contract rent is a form of rent that is stipulated in a lease.
• In other words, it refers to the actual rental income specified in a lease.
• Contract rent can be equal to, less than or greater than market rent.
383
Effective Rent
• Effective rent is the rent net of financial concessions such as free of rent, during
the lease term.
Example:
 Suppose that the owner of a 1,000 square meter of office building has rented
it for 2,000 birr per month for three years term with level income throughout
the lease term. When the lease was negotiated, the tenant received free rent
for the first month of each year as a concession. So how much are the
contract rent and the effective rent per square meter per year?
258
CONT…
 The contract rent of the property in our example is
 24,000 birr /1,000 sq. m

 24 Birr per square meter
 According to the concession, the tenant has got a concession of free rent for the first
month of each year.
 Thus, the effective rent of each year is 22,000 birr.
As a result, the effective rent per square meter is:
 22,000 birr /1,000 sq. m

 22 Birr per square meter
259
Excess rent
• Excess rent is the amount in which the contract rent is above the market
rent at the time of the appraisal.
• It is usually short term in nature.
Deficient Rent
• It refers to the amount by which market rent exceeds contract rent at the
time of the appraisal.
260
RATES OF RETURN
• In applying income capitalization approach, an appraiser assumes that the
investor ultimately seeks a total return greater than or equal to the amount
invested.
• Thus, the investor’s expected return consists of two components.
• These are:
• Return of capital- it refers to the recovery of invested capital, usually
through income and reversion.
• Return on capital- it refers to the additional amount received as
compensation for the use of the investor’s capital until it is recaptured.
261
Cont.…
 Since returns from real estate may take a variety of forms, many rates of
return are used in income capitalization.
 All rates of return can be categorized as either
 Income rates which include overall capitalization rate and equity capitalization
rate, or
 Discount rates which include effective interest rate (the rate of return on debt
capital), yield rate, and rate of return.
Income Rates
 An income rate expresses the relationship between one year’s income and
the corresponding capital value of property.
262
Overall Capitalization Rate
• It is an income rate for a total property that reflects the relationship
between a single year’s net operating income of the property to the value
or sales price of that property.
• It is used to change the net operating income of a property into an
indication of property value.
• It considers an investor’s total expected return including both the return on
capital and a return of capital.
Equity Capitalization Rate
• It is an income rate that reflects the relationship between a single year’s
cash flow expectancy and the equity investment.
• It is used to convert the equity dividend into an equity value indication.
• It is also called cash on cash rate, cash flow rate or equity dividend rate.
Mortgage capitalization rate
• It is a capitalization rate for debt.
• It represents the ratio of annual debt service to the principal amount of the
mortgage.
• It uses annual debt service cash flow rather than operating income and
the original mortgage value instead of overall property value.
• It explores the relationship between annual debt service payments and
the principal amount.
Terminal capitalization rate
It is the capitalization rate used to calculate the resale value of a property.
390
Discount Rates
• Various sorts of discount rates are used to discount cash flows applicable
to a specific position or interest in a defined real estate.
• Discount rates may or may not be developed in the same way as internal
rate of return.
Internal Rate of Return
• An internal rate of return (IRR) refers to the yield rate that is earned for
a given capital investment over the period of ownership.
• It is the discount rate that equates the net present value of the property
zero.
391
.
Yield Rate
 Yield rate refers to the rate of return on capital. The term interest rate usually refers to
the yield rate for debt capital, not equity capital.
 It considers all expected benefits from the property over the income projection period,
including both annual net income and any remaining value or reversion. When yield
rate is used in yield capitalization to discount future income payments into value
indicator, it is referred to as discount rate
Overall Yield Rate

 It refers to the rate of return on the total capital invested. It is the most commonly
used yield rate.
 It takes all changes in income over the holding period and the reversion at the end of
the holding period into account.
 It can be viewed as the combined yield on both debt and equity. It is applied to cash
flow before debt services.
266
Equity Yield Rate
It is a rate of return on equity capital.
 It
may be distinguished from a rate of return on debt capital, which is
usually referred to as an effective mortgage interest rate.
The equity yield rate is the equity investor's internal rate of return.
Mortgage Yield Rate

It is the required rate of return on the mortgage. It is simply referred to
as interest rate.
 It is the rate at which mortgage values can be discounted into the
present value of the mortgage.
267
6.5 Income and Expense Analysis
• Income capitalization approach, both direct capitalization and yield
capitalization method, requires a comprehensive income and expenses
analysis of the subject property.
Potential Gross Income
• Potential gross income (PGI) is the total potential income attributable to
the property at full occupancy before operating expenses are deducted.
• Appraisers usually analyze potential gross income on annual basis.
• Potential gross income comprises:
 Rent for all space in the property
 Rent from escalation clauses
 Reimbursement(Compensation) income
268
Cont.…
 All other forms of income to the real estate-e.g., income from services
supplied to the tenants, such as antenna connections, storage, garage space,
parking fees etc.…
Vacancy and Collection Loss
 Vacancy and collection loss is an allowance(payment) for reductions in
potential gross income attributable to vacancies, tenant turnover, and non
payment of rent.
 This line item considers two components:
 Physical vacancy as a loss in income
Collection loss caused by concessions or default by tenants
269
Cont.…
 This allowance is usually estimated as a percentage of potential
gross income, which varies depending on
 The type and characteristics of the physical property
The quality of its tenants
The type and level of income streams
Current and projected market supply and demand conditions; and
National, regional, and local economic conditions.
 Published surveys of similar properties under similar conditions may
indicate an appropriate percentage allowance for vacancy and collection
loss.
 An appraiser
270 should survey the local market to support the vacancy estimate.
Effective Gross Income
• Effective gross income is calculated as the potential gross income minus the vacancy and
collection loss allowance.
Operating Expenses
• Operating expenses are periodic expenditures necessary to maintain the real property
and continue production of income, assuming prudent and competent management.
• Operating expenses are deducted from effective gross income
to arrive at net operating income.
• Operating expenses are divided into three categories:
1. Fixed expenses
2. Variable expenses
3. Replacement allowance
397
1. Fixed Expenses
• Fixed Expenses are considered fixed not because they
remain unchanged over time.
• Rather, they generally must be paid regardless of the occupancy or use of a
property.
• The management will pay fixed expenses whether the property is occupied or
vacant.
• Examples include insurance and real estate taxes.
2. Variable Expenses
• Variable Expenses are those expenses incurred in operating the property,
providing services to the tenants and maintaining the income stream.
398
Cont. ..
These expenses are directly related to occupancy levels.
Major variable expense categories include:
 Management charges
 Administrative and Leasing expenses
 Utilities-e.g., electricity, gas, water, and sewer, heating
 Grounds maintenance expenses
 Building maintenance expenses
 Redecorating expenses
 Miscellaneous-e.g., security, supplies, rubbish removal
399
Management Charges
• The expense of management is usually expressed as a percentage of effective
gross income and conforms to the local pattern of such charges for typical
management.
• The operation of multitenant properties requires a considerable amount of
supervision, accounting, and other services.
• Other management expenses may include the cost of telephone service, clerical
help, legal or accounting services, printing and postage, and advertising and
promotion.
Administrative and Leasing Expenses

• Are those expenses associated with the day-to-day operation of the property.
400
Cont..
 Included in this category are the following:
 On-Site Management: Particularly for larger multi-tenant properties, it is
common to have a property manager on the site.
 Office and Leasing Expense: Payroll and benefit costs associated for
leasing agents, secretarial and general office personnel where necessary
for the operation of the property. Other expenses could include office
supplies, materials, telephone, internet, credit bureau reports, postage and
office equipment.
 Advertising expense: It includes newspaper, billboards, radio, internet and
other special promotions.
 Advertising expenses can fluctuate and are closely associated with
occupancy.
401
Utilities Expense:
• It includes gas, electricity, water and sewer charges, and heating costs if
provided by the landlord as part of the monthly rental can be a major
expense for a property.
 When reviewing utilities expense for a property it is important to determine
which expenses are paid by the landlord and which are paid by the tenant.
Ground Maintenance Expenses:

• They are those expenses incurred in maintaining lawns, parking areas and
private streets. Included in this category could be
 Grounds labor for lawn and landscaping care,
 Snow removal and repairs to sidewalks,
 Parking areas and streets
 Swimming
402
pool related expenses
Building Maintenance Expenses:
• This category includes expenses that are incurred in maintaining the exterior of the
buildings as well as common areas.
 Labor charges can include roof repair, exterior painting, structural repair work, window
washing and general cleaning.
 Building repair supplies includes electrical, plumbing and heating repair parts, window
glass replacements, exterior paint, and building cleaning supplies.
Redecorating Expenses:
• This category includes the labor expense of cleaning, painting interior walls, cleaning
floor coverings.
 Redecorating supplies include paint, cleaning supplies and other supplies.
403
Miscellaneous Expenses
• Include those small expenditures not assigned to another expense category.

• Security expenses are typical for this category.
 This expense category should be a minor percentage of effective gross
income.
3. Replacement Allowance
 It is an allowance that provides for the periodic replacement of building
components that wear out more rapidly than the structure itself and must be
replaced during a buildings economic life.
 If a reserve for replacement is used, these items should not be included in
repair and maintenance categories in the reconstructed income and expense
statement
404 .
Cont..
 Building Components Requiring Replacement Allowance
Roof covering
 Carpeting
 Kitchen, bath, and laundry equipment's
 Compressor, elevator, and boilers
Specific structural items and equipment's that have limited
economic life expectancies etc…
 After the appraiser reaches a value for net operating income, further
calculations may be needed to determine
 Mortgage debt service
 Equity dividend

405 Expense and income ratios
Mortgage Debt Service
• Mortgage debt service is the annual sum of all mortgage payments.
• Mortgage debt service is deducted from net operating income to derive
equity dividend, which is used in certain capitalization procedures.
Equity Dividend
• Equity dividend is the income that remains after all mortgage debt service is
deducted from net operating income.
Expense and Income Ratios
• The ratio of total operating expense to effective gross income is the
operating expense ratio (OER).
• The complement of this ratio is the net income ratio (NIR), which is the
ratio of net operating income to effective gross income.
280
Operating Income Statement
Potential Gross Income (1)
Vacancy and Collection Loss (2)
Effective Gross Income (1)-(2)=(3)
Operating Expenses
Fixed Expenses x
Variable Expenses xx
Replacement Allowance xxx
Total Operating Expenses xxxxxx= (4)
Net Operating Income (3)-(4)=(5)
Debt Service (6)
Before Tax Cash Flow (5)-(6)=(7)
Income Tax (8)
281
After Tax Cash Flow (7)-(8)=(9)
6.6 Methods of Income Capitalization
• There are two methods of income capitalization.

• These are:
• Direct Capitalization
• Yield Capitalization
6.6.1 Direct Capitalization
• Direct capitalization is a method of income capitalization used to convert a
single year’s income expectancy of the subject property in to a value
indication.
• It has only three working parts:
• Net operating income,
• Overall capitalization rate, and
409
• Property value.
Net operating income
 In this method a property’s market value is estimated by dividing a single
year’s net operating income (NOI) by a capitalization rate.
 This conversion is accomplished in one step, either by dividing the income
estimate by an appropriate income rate.
 Appraisers usually apply direct capitalization method when properties are
already operating on a stabilized basis and enough comparable sales available
in the market.
 However, it may not be feasible to use it since there is a possibility of
irregularity in change income and/or expenses pattern over time
410
 The basic formula of direct capitalization is
MV = NOI
R
where
 MV is market value
 NOI is stabilized net operating income
 R0 is the capitalization rate.
• The following are the basic assumptions behind the direct

capitalization approach.
• It usually involves comparable sales to develop cap rate
• It does not require explicit projection of income for the subject property
411
CONT…
 Itassumes that expectation for future incomes are similar for the subject
and the comparable from which the rates are extracted
 Reliable income rates from sales must be obtained
Example:
Suppose that an investor is considering the purchase of a rental property
with a net operating income of birr 50,000. Suppose also that this investor
has a desired rate of return (capitalization rate) of 10%. Determine the
market value of this property based on the above information.
Market value = NOI/capitalization rate
MV =50,000/0.1
MV = 500,000 birr
412
Derivation of Overall
Capitalization Rates
• Overall capitalization rates can be estimated with various techniques. The
techniques used depend on the quantity and quality data available.
• When supported by market data, accepted techniques include derivation from:
 Comparable sales
 Effective gross income multipliers and net income ratios
 Band of investment-mortgage and equity components
 Band of investment-land and building components
 The debt coverage formula
286
Derivation of Capitalization rate based on
Comparable Sales
R  N O I
M V
 Overall capitalization rate can be derived from the comparable sales data
provided that we have the sales price of comparable and their respective net
operating income.
 This method of estimating the overall capitalization rates is referred to as direct
market extraction.
 The estimated capitalization rate can be applied to capitalize the estimated first year
NOI of the subject property in to an estimate of market value.
287
CONT…
Comparables NOI Sales Price Overall cap rate
A 80,000.00 825,000.00 0.097
B 114,000.00 1,200,000.00 0.095
C 100,000.00 971,000.00 0.103
D 72,000.00 713,000.00 0.101
E 90,000.00 910,000.00 0.099
Average 0.099
288
Derivation of Ro from Effective Gross Income Multipliers and NIR
• An effective gross income multiplier can be derived and used in conjunction with
a net income ratio (NIR) to produce an overall capitalization rate.
• The NIR is the complement of the operating expense ratio (OER).
Thus, NIR = 1 - OER.
• The net income ratio is the ratio of net operating income to effective gross income.
• The operating expenses ration is the ratio of operating expenses and effective
gross income.
• The formula for deriving an overall capitalization rate from a net income ratio and
an effective gross income multiplier is
NIR
R0 
EGI
416
M
CONT..
Example:
Considering a property which was recently sold for 500,000 birr has a potential gross
income of 80,000 birr and a vacancy and collection loss of 6.25% of the PGI.
Determine the overall capitalization rate based on the EGIM assuming that the
operating expense is estimated to be 30,000 birr. Determine the overall capitalization
rate given this information.
Sales Price of a Property in Birr 500,000
Potential Gross Income 80,000
Vacancy and collection loss (6.25% of PGI) 5,000

Effective Gross Income (EGI) 75,000
Operating Expenses 30,000
Net Operating Income (NOI) 45,000
Net Income Ratio (NIR) = NOI/EGI 0.6
Effective gross income multiplier (EGIM)=Sales price/EGI 6.67
290
The overall capitalization rate = NIR/EGIM 0.09
CONT…
NIR
R0  0.6
EGIM  6.67  0.09 or 9%
Derivation of Ro by Band of Investment-Mortgage and Equity

• Real estate market is composed of equity investors and lenders.
• Both parties are considered as investors.
• They combine their resources to create band of investment.
• The band of investment method produces a capitalization rate which is a
weighted average of these components.
• This method combines a rate for mortgage loan money and a rate for the
investor’s
291
equity money.
CONT….
 Lenders must anticipate receiving a competitive interest rate commensurate
with the perceived risk of the investment or they will not make funds
available.
 Lenders generally require that the loan principal be repaid through periodic
amortization payments.
 Similarly, equity investors must anticipate receiving a competitive equity cash
return commensurate with the perceived risk, or they will invest their funds
elsewhere.
292
CONT..
 When the mortgage and equity capitalization rates are known, an overall
capitalization rate may be derived with the band of investment or weighted-
average, technique using the following formulas:
R0 = (MxRM ) + (ExRE )
 Where
 M represents the loan to value ratio,
 Rm represents the mortgage capitalization rate,
 E is the equity portion of the property investment and
 Re represents the equity capitalization rate.
293
CONT..
Example:
Les us assume that 70% of the property investment is financed from loan
which has 9% interest rate and with duration of 30 years. Determine the
overall capitalization rate provided that the mortgage capitalization rate is
11% and the equity capitalization rate is 7% as it has been derived from the
comparable sales.
The overall capitalization rate is calculated as follows
R0 = (0.7x0.11) + (0.3x0.07)
R0 = 0.098 or 9.8%
294
Derivation of Ro by Band of Investment – Land and Building
• The overall capitalization rate can also be determined based on land and building
values.
• Although the elements addressed in this method are the physical components of a
property, we are going to use similar technique that we have used for mortgage
and equity, i.e., a band of investment technique.
• Similar to that of mortgage and equity, weighted rates can be developed for the
land and buildings
• The formula that can be used to calculate the overall capitalization rate using this
method is
R0  (LxRL ) (BxRB )
295
CONT…
 Where
 L represents the land value as a percentage of property value,
 RL represents land capitalization rate,
 B is the building value as a percentage of total property value, and
 RB represents building capitalization rate.
Example :
 Calculate the overall capitalization rate give that land takes 22% of the property value
and the improvement (building) represents the remaining 78% of the property value.
Assume that the land capitalization rate extracted from the comparable sales is 7%
and the building capitalization rate is 11%.
 The overall capitalization rate is
R0 = (0.78x0.11) + (0.22x0.07
R0 = 0.1012 or 10.12%
423
Derivation of Overall Capitalization Rate from Debt Coverage
Formula
• The overall capitalization rate can be computed from the debt coverage ratio
(DCR).
• It is the ratio of net operating income (NOI) of the property to the annual
debt service.
• It shows the ability of the property to cover its debt service out of its net
operating income (NOI).
• IM
DCR= NOI
I
 According
24
to this method the overall capitalization rate is
R0 = DCRx RM x M
• Where
• M is the loan to value ratio,
• RM is the mortgage capitalization rate and
• DCR is the debt coverage ratio.
Example
• Calculate the overall capitalization rate of the property which can generate a net
operating income of 100,000 birr per year and annual debt service of 68,135 birr.
65% of the property is financed through bank loan with mortgage capitalization rate
of 0.112.
• First we have to calculate the DCR which is the ration of net operating income to the
annual debt service
DCRI
NOI  100,000
M
68,135
D
425
CR 1.47
CONT….
 The overall capitalization rate is
R0 = DCR x RM x M
R0 = 1.47 x 0.112 x 0.65
R0 = 0.107 or 10.7%
Residual Techniques(Property value)

 Residual technique is categorized under direct capitalization method.
 It is a procedure used to capitalize the net income allocated to an investment
component of unknown value after all investment components of known values have
been fulfilled.
299
CONT..
 It may be applied to a property’s
 Physical components (land and building) and
 Financial interests (mortgage and equity).
 The residual technique separates net operating income into various
components such as land and building or mortgage and equity.
There are different residual techniques used in direct capitalization.
These are:
Building residual technique
Land residual technique
Equity residual technique
Mortgage residual technique
300
Building Residual Technique
• The value of a property can be determined using this technique if the value
of the land is known and the value of the building is unknown.
• This technique allocates the net income of the property to both land and
building.
• The procedure that should be followed in this technique is:
• Multiply the known land value by the applicable interest (i.e., return) rate
to determine the income attributable to land.
• This income is deducted from the net operating
income of the property to arrive at income associated to building.
• Divide the income attributable to building by building capitalization rate to
get building value.
• Add building value to land value to arrive at value of the property.
428
Example:
CONT….
• Suppose that there is a subject property with land value 500,000 birr and the interest rate
attributable to land is 8%. Determine the value of the subject property provided that the
building capitalization rate is 11% and the NOI of the property is estimated to be 205,000
birr using direct capitalization method/building residual technique.
NOI ------------------------------------------------------------ 205,000
Less: Land value x 0.08(500,000 x 0.08) ------------------ 40,000
Building income ------------------------ ------------------------165,000
Building value (165,000/0.11) ---------------------------------1,500,000 birr
Property value = Land value + Building value
= 500,000 + 1,500,000
= 2,000,000 birr
429
Land Residual Technique
• The value of the property can be estimated using this technique when the
building value is known and the land value is unknown.
• Land residual technique is similar to the building residual technique except
that the appraiser must first find the income attributable to the building.
• The appraiser has to follow the following procedure in estimating the value
of a property using the land residual technique:
• Multiply the building value by the building capitalization rate to
determine the income attributable to the building.
• Deduct this income from the NOI of the property to get income
attributable to the land.
303
CONT…
• Divide the land income by the land capitalization rate or the given
interest rate to arrive at land value.
• Add value of land to the building value to arrive at the value of the
whole property by the land residual technique.
Example:
• Determine the value of a property using the land residual technique given
an estimated building value of birr 750,000, a land capitalization rate of
9% and an 10% building capitalization rate. The net operating income of
the subject property is estimated to be birr 100,000.
304
CONT….
Building value -------------------------------------------------------- 750,000
NOI -------------------------------------------------------------------- 100,000
Less: Building income(Building value x 0.1)750,000 x 0.1 -----75,000
Equals: Land Income -------------------------------------------------25,000
Land value (25,000/0.09) ------------------------------------ -------277,778
Property value (Building value + Land value) ------------- -------1,027,778
305
Equity Residual Technique
• The value of a property can be estimated using the equity residual
technique when the amount of mortgage is known and the amount of
equity is unknown.
• An appraiser has to follow the following procedure to determine the
value of a property using this technique:
• Subtract the annual debt service from the net operating income of a
property to estimate the equity cash flow to the investor
• Divide the equity cash flow by the equity capitalization rate to get
the indicted value of equity
• Add the indicated value of equity to the mortgage amount to arrive at
the estimated value of a property
306
CONT…
Example:
Determine the estimated value of a property, using equity residual technique, which can
generate a net operating income of 100,000 birr, with loan amount (mortgage amount) of
600,000 birr and the annual mortgage debt service (annual loan payment) is 70,000 birr
and equity capitalization rate of 7%.
Net operating income -------------------------------------------------- ---------------100, 000

•Less: Mortgage Debt service ---------------------------------------------------------70,000
•Equals: Equity cash flow --------------------------------------------------------------30,000
•Equity value (Equity cash flow/capitalization rate)(30,000/0.07) ---------------429,000
•Plus: Mortgage amount ----------------------------------------------------------------600,000
•The value estimate of the property ---------------------------------------------------1,029,000
434
Mortgage Residual Technique
• Property value can be estimated using this technique when equity value is the
known component and the mortgage value is unknown.
• An appraiser has to follow the following procedure to determine the value
of a property using this technique:
• Multiply the equity value by the equity capitalization rate to get the
income attributable to equity.
• Subtract this income from the NOI of the property to arrive at income
attributable to mortgage.
• Divide mortgage income by mortgage capitalization rate to get
mortgage value.
• Add equity value and mortgage value to arrive at property value.
308
CONT….
Example: Estimate the value of a property which can generate a net operating income of
50,000 birr and has an equity amount of 250,000 birr with equity capitalization rate of
8%. Suppose that the mortgage capitalization rate is 0.10.
Equity amount/value -----------------------------------------------------------250,000

• Net operating income ---------------------------------------------------------50000
• Less: Equity value x equity capitalization rate (250,000 × 0.08) -------20000
• Residual income to mortgage ------------------------------------------------30000
• Plus: Capitalized Mortgage value(30,000/0.10) ---------------------------300,000
Value of the property -----------------------------------------------------------550,000
309
Advantage and Disadvantage of
Direct Capitalization
Advantage
• Direct capitalization is usually the preferred method as it is perceived to
be simple to use and explain.
• It has only three working parts namely:
• NOI
• Overall Capitalization rate
• Market Value
• It provides strong market value support when there is enough sales data.
310
Disadvantage
• Since the capitalization rates are determined using the forecasted NOI for only
the next year, the capitalization rate formula doesn’t consider the changes that
may occur in subsequent years.
• It doesn’t consider that time value of money.
• It doesn’t consider the overall return an investor may receive from future cash
flows.
• It is difficult to apply this method if it is not possible to get enough comparable
sales data.
311
6.6.2 Yield Capitalization
• Yield capitalization is a method of converting future economic benefits,
especially periodic income stream/cash flow and reversion of ownership
into present value.
• Cash flow refers to the periodic income attributable to the interests in real
property.
• The procedure used to convert these future economic benefits into present
value is called discounting.
• The required rate of return (or yield rate) used in this method is referred to
as the discount rate.
312
CONT…
• To use this method, an appraiser
• Selects an appropriate holding period
• Forecasts all future cash flows or cash flow patterns (including the reversion)
• Chooses an appropriate yield rate
• Converts future benefits into present value by discounting each annual future
benefit including reversion.
Discounting
• Discounting is a procedure used to convert periodic income/cash flows, and
reversions into present value based on the concept that benefits received in
the future are worth less than the same benefits received now.
313
CONT…
• The discount rate is the interest rate used for discounting process and may be the
property yield rate, equity yield rate or other defined rate.
• In real estate appraisal practices, the most commonly used rate is the property
yield rate (Yo).
• The standard formula of discounting future value into
present values is:
Future value
Pr esent value 
(1 
r)n
Wher
e “r”
 is the rate of return on capital per period (discount rate) that will
satisfy the investor and
 “n” is the number of periods that the payment will be deferred.
1
 is the discount
441 1r
n factor
CONT….
 If there are cash flows for several years such as CF 1, CF2,CF3……
CFn, the present value of such cash flows can be calculated as
C F1 CF2 C F3 CFn
PV     . . .. 
1  r 1  r
2
1  r
3
1  r
n
   
Using a summation
sign n
CF
PV 
 i 1 1 
i
r i
315
Discounted cash flow
 Discounted cash flow (DCF) analysis is appropriate for any pattern of regular
or irregular income.
 In DCF analysis, an appraiser can discount each payment of income and
reversion separately and add all the present values together to get the present
value of the property being appraised.
 The DCF formula treats the reversion as a cash flow that can be valued
separately from the income stream.
316
CONT…
Using this formula the estimated value of the property which generates
income might be:
NOI1 NO I2 NO I3 NOIn 1
PV     ....   NOIn  1  )
1  r 1  r  1  r
2
1  r   r  g  ( 1  r

n
  3
 n

Wher
e represents the discounted reversion value (salvage
 NO I n 1 
1 n
 r  g  1  r
value)
(r-g) is the exist yield
“g” is the rate of inflation or growth rate
“r” is the discount rate/yield rate.
NOI is the net operating income of the
property444
 “n” is the number of years
CONT…
 Discounted cash flow analysis requires appraisers to follow certain
procedures to determine the net operating income from the potential gross
income of the property.
 Estimate the potential gross income of the property
 Project vacancy and collection loss
 Deduct the vacancy and collection loss from the potential income and determine
the effective gross income of the property
 Estimate the operating and maintenance expenses of the property
 Deduct the operating and maintenance expenses from the effective gross income
of the property and find the net operating income of the property
 Determine the time of reversion
318
CONT…
 Typical forecast categories to be addressed in DCF analysis include:
Current market rental rates and expected rate changes
Existing base rants and contractual base rents
Renewal options
Existing and anticipated expenses recovery provisions
Tenant turnover
Re-leasing assumptions including new lease terms, vacancy and
collection loss, existing lease expiration
Operating expenses
Net operating income
Reversion
Discount rate
319
CONT…
Example 1:
• Suppose a property to be appraised is expected to produce a first-year net
operating income of 100,000 birr, which is expected to increase at 3
percent per year over a six-year holding period. At the end of the holding
period, it is anticipated that the property can be sold for 1,000,000 birr net
of sales expenses. The appropriate yield rate for this investment is
concluded to be 13 percent. Determine the market value of the property
using DCF technique.
320
CONT…
Year 1 2 3 4 5 6
NOI 100,000 103,000 106,090 109,273 112,551 115,927
Discounted NoI 88,496 80,664 73,526 67,019 61,088 55,682

Total discounted
NoI 426,475
Sales price at the

end of the 6th year 1,000,000
Discounted
Reversion 480,319
Market value 906,793
321
CONT… …..
Example 2:
• Suppose that the initial rent for a commercial property is 20 birr/square
meter per year. If the gross building area is 24,000 square meter, the net
leasable area is 20,000 square meter, the vacancy and collection loss is 6%
of PGI and if operating and maintenance(O&M) expenses are initially
estimated to be 4.10 birr/square meter per year. Forecast the NOI of each
year for a 10- year holding period. Knowing that the opportunity cost of
capital is 10% and the rate of inflation is 2% what would be the market
value of the property?
322
Year 1 2 3 4 5 6 7 8 9 10 11
Net leasable area 20,000 20,000 20,000 20,000 20,000 20,000 20,000 20,000 20,000 20,000 20,000
Rent / sq.m 20.0 20.4 20.8 21.2 21.6 22.1 22.5 23.0 23.4 23.9 24.4
PGI 400000 408000 416160 424483432973 441632 450465 459474 468664 478037 487598
Vacancy rate 0.06 0.06 0.06 0.06 0.06 0.06 0.06 0.06 0.06 0.06 0.06
Vacancy loss 24000 24480 24970 25469 25978 26498 27028 27568 28120 28682 29256
EGI 376000 383520 391190 399014406994 415134 423437 431906 440544 449355 458342
O&M /sq.m 4.1 4.2 4.3 4.4 4.4 4.5 4.6 4.7 4.8 4.9 5.0
O&M per sq.m 82000 83640 85313 87019 88759 90535 92345 94192 96076 97998 99958
NOI 294000 299880 305878 311995318235 324600 331092 337714 344468 351357 358384
Discounted NOI 267273 247835 229810 213097197599 183228 169902 157546 146088 135463
Total
Discounted NOI 1,947,841
Discounted
resale value 1,727,159
Market value 3,675,000

323
CONT….
Exercise
• Suppose that the initial rent for a commercial property is 25 birr/square
meter per year. If the net leasable area is 10,000 square meter, the vacancy
and collection loss is 5% of PGI and if operating and maintenance (O&M)
expenses are estimated to be 5 birr/Square meter per year. Forecast the NOI
for a 10-year holding period. Knowing that the opportunity cost of capital is
10% and the rate of inflation is 3% what would be the market value of the
property?
324
Advantage and Disadvantage of Yield Capitalization
(DCF Analysis)
Advantage
• It is forward looking rather than historical results.
• It is relying on the fundamental expectations of the business or asset
• It focuses on cash flow generation and less affected by accounting practices
• It allows different components of a property to be valued separately
• It permits any or all of those variables to change over time
• It considers the time value of money that involves the various types of risks.
452
Disadvantage
• Since it is an attempt to estimate intrinsic value, it requires far more
inputs and information than other valuation approaches
• If future cash flows are not accurately predicted, this method cannot be
applicable.
• The discount rate assumption relies on the market for competing
investments at the time of analysis, which would likely change, over
time.
• Straight line assumptions about income increasing over certain years are
generally based upon historic increase in market rent but never factors
the cyclical nature of many real estate markets
• Terminal value usually represents larger percentage of the total DCF
valuation.
453
Unit 7
Reconciliation of Value Indication and
Reporting Appraisal
7.1 Introduction
 The appraisal process typically involves three approaches to value.
 Each approach may have one or more methodologies that are utilized in estimating the value
of a property. They may produce different value for a single subject property.
 In a perfect world, all the methods used would result in the same
value.
 Unfortunately, given the property valuation, it is inevitable that each methodology will
generate a unique value estimate that differs from the other methodologies.
 Thus, appraisers should resolve the difference among value indicators and end up with a
single or a range of values
54 .
LaSu abay 327

• Real estate appraisal, the process of resolving the
difference among value indicators is called
reconciliation.
7.2 Reconciliation and Final Value Estimate
• Reconciliation can be defined as the last phase of any
valuation assignment in which two or more value
indications derived from market data are resolved into
final value opinion which may be either
I. a single point estimate or
II. a final range of values
• In the process of reconciliation, the appraiser should
consider the relative applicability of each of the three
approaches to arrive at the final value estimate of defined
455 value.
LaSu abay 328

 The final value opinion does not simply represent the average of
the different value indications obtained.
 A final reconciliation relies on the proper application of appraisal
techniques and the appraiser’s judgment and expert opinion.
7.2.1 The Process of Reconciliation
 Before reconciling the multiple value indications of a property,

an appraiser has to review:
The purpose and use of the appraisal,
Relevance and adequacy of data gathered and
All tasks previously carried out to be sure that an adequate
appraisal was performed and can lead to consistent judgment.
456
LaSu abay 329

Review of the Appraisal Process
 In reviewing the appraisal process, all previous works and analysis
are checked and verified.
 It is a good starting point for reconciliation.
 At this stage of the valuation process, the appraiser has to ask the
following questions:
√ Is the property precisely located and identified?
√ Are the property rights to be appraised clearly identified?
√ Have the agreed scope of work and the purpose of the appraisal
been considered?
√ Is the effective age of the property used in the cost
approach consistent with the physical condition
reported?
330
LaSu abay
• Is the same physical condition assumed in making
adjustments to rent comparables, expense comparables, and
sales comparables in the income and sales comparison
approaches?
• Are the results of all the approaches consistent with the
appraiser's conclusion of highest and best use?
• Do the indications derived from the approaches applied
reflect the same defined value?
• Reviewing an appraisal helps us to ensure its
Accuracy
Consistency, and
The logic leading to the value indications
• An appraiser relies more on professional experience and
judgment in reconciliation than in any other part of the
valuation process.
459
LaSu abay 331

 The appraiser weights the relative significance, applicability, and
defensibility of each value indication and relies most heavily on
the approach that is most appropriate to the nature of the appraisal
problem.
Reconciliation Criteria
 In theory, the different valuation approaches and methods used
should produce a relatively narrow range of value indications. This
is not always the case. Value indications may be divergent.
 The following are reconciliation criteria with which an appraiser
forms a meaningful final value opinion:
Appropriateness
Accuracy and
Quantity of evidences
LaSu abay 332

Appropriateness
 The appropriateness of an approach to the intended use of
the
appraisal is usually directly related to property type.
For instance:
It often gives little sense to use an income approach when you
are appraising a special use property such as Museum, Church,
Mosque and etc.The cost approach would be more appropriate
for such properties.
It is justifiable to use sales comparison approach to estimate the
value of a property for which good comparable sales are
available in the market and income data is scarce.
The income approach is more relevant for the income
generating properties.
461
LaSu abay 333

Accuracy
The accuracy of an appraisal is measured by the
appraiser’s confidence in the accuracy of data and the
adjustments made to each comparable property
analyzed.
The approach which is considered to be more reliable in
the appraisal at hand should be given the greater weight
in arriving at the final value conclusion.
Quantity of Evidences
When using any generally accepted approach to value,
the quantity of data used should be adequate to provide
reasonable support for the value indicator.
LaSu abay 334

7.2.2 Final Opinion of Value and Rounding
 In an appraisal report, the final opinion of value may be stated as
A single figure
A range of values or
In relation to a benchmark amount (e.g “not more than” or “not
less than”)
 Traditionally, an opinion of value is reported as a single monetary
amount called point estimate.
 A point estimate is required for many purposes:
 Real estate taxation
 Calculating depreciation deductions for tax
 Estimating compensation in casualty, liability, and condemnation
cases
 Determining value-based rent
 Making property transfer decisions
335
LaSu abay 335

• It may also be stated as a range of values if it is specifically stated in
the appraisal assignment and the agreement with the client.
• There is no magic method to reach to a final value opinion of the
property.
• Arriving at a final value opinion is the most difficult task in the
appraisal process. However, it is sometimes justifiably a weighted
average of the three value indications.
• After giving full consideration to each approach, the appraiser
uses judgment and reasoning to arrive at one conclusion.
The final value conclusion should not be reported in odd birr and
cents rather it should be rounded to reflect the degree of precision
the appraiser can associate with the particular opinion of value.
336
LaSu abay 336

There are no standards of practice for rounding. Often
the manner in which the figure is rounded is a matter
of convention- e.g., to two or three significant digits.
For example, if the final value estimate is a six-digit
number, the figure will likely be rounded to the
nearest thousand or ten thousand birr. In other words,
the value 233,495 birr can be rounded to 230,000 birr
or 233,000 birr.
337
LaSu abay 337

7.3 Appraisal Report
The essence of property valuation is to arrive at a
conclusion of value that is both reasonable and
supportable.
After the appraisal task has been carried out, the
appraiser has to formally communicate the details of the
task performed to the client through a report.
The process and the result may be communicated to
the client or other users either through orally or in
writing.
The appraisal report must include certain minimum
elements that are required to satisfy practical,
professional, and legal requirements.
338
LaSu abay 338

7.3.1 Standards of Written Reports
The appraisal report leads the reader from the
1. Definition of the appraisal problem
2. Analysis and relevant descriptive data
3. Specific conclusion.
The length, type and content of the appraisal report are
dictated by
The intended use and purpose of the appraisal,
The nature and complexity of the problem solved.
469 .
LaSu abay 339

• Reporting requirements may differ from one client to
another client depending on the purpose and
intended use of the appraisal.
• Thus, the form and the general content of appraisal
report is a matter to be agreed in between the client
and the appraiser as part of defining the scope of
work to be performed.
• Preamble to the Uniform Standards of Professional
Appraisal Practice (USPAP)states:
• It is essential that professional appraisers develop
and communicate their analyses, opinions, and
conclusions to intended users of their services in a
manner that is meaningful and not misleading
• Standard 2 of USPAP sets forth the requirements for
reporting an appraisal of real property.
LaSu abay 340

Standards Rule 2-1
• States that each written or oral real property
appraisal report must:
• Clearly and accurately set forth the appraisal in a
manner that will not be misleading;
• Contain sufficient information to enable the
intended users of the appraisal to understand the
report properly
• Clearly and accurately disclose any extraordinary
assumption, hypothetical condition, or limiting
condition that directly affects the appraisal and
indicate its impact on value.
470
LaSu abay 341

Standards Rule 2-2
• Requires that each written appraisal report be
prepared under one of the following three options,
which must be prominently stated in the report:
1. Self-contained appraisal report
2. Summary appraisal report
3. Restricted use appraisal report
The essential difference between the three reporting
options is the level of detail required in certain
areas of presentation and the accompanying work
file
471 . LaSu abay
342
471
LaSu abay 343

7.3.2 Types of Reports
A final value opinion of a property may be communicated
to the client orally or in a written form.
Written report prepared under one of the three reporting
options mentioned above may be form or narrative reports.
An appraisal report is often prepared in a way requested
by the intended user.
1. Oral Reports
An oral report may be carried out when the circumstances or
the needs of the intended user do not permit or demand
a written report
472
.
LaSu abay 344

The most common form of oral reporting is performed
to clients in person or by telephone when appraisers
are asked for the opinion of value only.
Expert testimony presented in court is considered an
oral report.
Each oral report must include the underlying bases of
the appraisal, especially any extraordinary assumptions
or hypothetical conditions used.
After communicating an oral report, the appraiser
must keep on file all notes and data relevant to the
assignment
345
LaSu abay 345

2. Written Report
 Written report may be form or narrative report.
 The type of a report that will be prepared determines the extent
of file documentation.
A self-contained appraisal report includes detailed
descriptions of the data, reasoning, and analyses used to
arrive at the value conclusion. In this case, the appraiser is
expected to have less file documentation.
A restricted appraisal report contains virtually none of this
information which needs the appraiser to keep more file
documentation.
The summary appraisal report contains some, but not all,
of the descriptive information gathered in the appraiser's
analysis.
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3. Form Reports
Institutions and agenciesthat regularly contract for
appraisals require the use of standard form appraisal report.
Most form reports may be classified as summary appraisal
reports, depending on the level of detail and the quantity of
supporting documentation.
Form reports often meet the needs of financial
institutions, insurance companies, and government agencies.
Form reports are often preferred by appraisers and clients
since they are usually designed in a standard check list
format on a printed page
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Narrative Appraisal Report
The narrative appraisal report is the most formal of the
written appraisal report.
It is perhaps the ideal format for self contained report.
Narrative reports are preferred when the user needs to
have comprehensive appraisal document.
In this type of report appraisers can fully explain what
they have related to the valuation process to persuade
the reader about the reliability of the final value
estimation of the property.
It is more detail than form report. It is descriptive in
nature.
It is most commonly used for commercial appraisals.
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7.3.3 The Basic Appraisal Report Format
The appraisal report should be formal organized report.
The structure of the report should be as user friendly as
possible, logical, sequential in the presentation of the
valuation conclusion and precise in value statements.
The appraisal report must contain three
catagorize of information:
Appraisal-specific information
Item-specific information
Supporting documentation
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Appraisal specific information:
• It includes
 USPAP report format option employed
Identify the client and other intended users
Ownership interest
Definition of value
Effective date of appraisal
Scope
Professionalassistance provided by others
Valuation approach
Markets researched
Limiting conditions and hypothetical conditions
Location
Responsible parties
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Item specific information
 Item description
 Quantity and quality characteristics
 Physical attributes
 Economic attributes
 Condition and Age
 Description of authentications, grading or tests performed
 Significant client information r
 Comparable market data and value issues (if item specific
in nature)
 Photographs
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Supportive Documentation:
• It can be attached to the report as addenda.

The appraiser’s professional profile
Copies of authentications
Glossary or abbreviations used
Bibliography of reference resources
Artist chronology
Diagrams or sketches
Photographs
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 Most narrative appraisal reports have four major parts.
 These are:
Introduction,
Premises of the appraisal,
Presentation of data, and
Analysis of data and conclusions
 In addition to these, several reports include the addendum or
appendix which includes additional information which

supplements the description in the major report parts information.
 The general outline of the narrative report which includes the four
main subdivisions is stated as follows

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General Outline of Narrative Appraisal Report
Part One: Introduction
Titlepage
Letter of transmittal
Table of contents
Certification
Summary of important conclusions
Part Two: Premises of the Appraisal

Identification of type of appraisal and type of report
Extraordinary assumptions and hypothetical conditions
General assumptions and limiting conditions
Purpose and intended use of the appraisal
Definition of value and date of opinion of value
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Property rights appraised
Scope of work
Part Three: Presentation of Data

Identification of the property
Identification of any personal property or other items that are
not real property
History, including prior sales and current offers or listings
Market area, city, neighborhood, and location data
Land description
Improvement description
Taxes and assessment data
483 Marketability study if appropriate
LaSu abay 355

Part Four: Analysis of Data and Conclusions
Highest and best use of the land as though vacant
Highest and best use of the property as improved Land
value
Cost approach
Sales comparison approach
Income capitalization approach
Reconciliation and final opinion of value
Estimate of exposure time
Qualifications of the appraiser
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Addenda or Appendix
Detailed legal description, if not included in the
presentation of data
Detailed statistical data
Leases or lease summaries
Other appropriate information
Secondary exhibits
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Rea Property Valuation(LaSu-4083)

• Course title: RP Valuation

• Using analysis effectively

becoming familiar with various concepts of value;

being able to logically gather and analyze data that is

understanding the various methods of property valuation

This course provides basic definition, concepts and

property valuation practices in Ethiopia.

The art is the skill of knowing which information to use to assist

Investment counseling, decision making and accounting

 In the market place, value is usually considered as an anticipation of benefits to

 To avoid confusion, appraisers don’t use the word value alone.

• Market value is the most probable price, as of a specified date, in cash or in

Arms-length transaction means a transaction between unrelated parties under

Assessed value- refers to the value of the property determined for

Scarcity - is the present or anticipated supply of an item relative to

Desire - An item must be needed by potential buyer to have value.

The rental and price pattern of existing properties

Externalities: the principle of externalities holds that factors external to the

II. provides a model for performing

o applying appraisal techniques

III. provides a checklist for appraisers and users of appraisal services

IV. Complies(act in accordance) with the Uniform Standards of Professional

1. Step 1 Definition of the Problem

2. Step 2 Scope of Work

3. Step 3 Data Collection and Property Description

4. Step 4 Data Analysis

5. Step 5 Land Value Opinion

6. Step 6 Application of the Approaches to Value

7. Step 7 Reconciliation(Bringing together) of Value Indications & Final Opinion of

8. Step 8 Report of Defined Value

In a given valuation assignment, more than one approach to value is usually

approaches are to be used.

Step 5- Land Value Opinion

1. Sales comparison approach

A property's income and resale value upon reversion may be

capitalized into a current value.

There are two methods of income capitalization:

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• Analysis of Urban Growth Structure

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• Inferred Demand Studies

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• Relies upon broadly based surveys of the market for

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