Property Valuation: Part 2

By in News You Can Use with 0 Comments

In the preceding paragraphs, I have outlined the most common approaches to the valuation of residential property. Nearly all residential appraisals will utilize the comparable market data and the cost approaches to determining value. Extrapolating value from dissimilar property types is seldom used; I should say that it seldom appears in a report. In rural areas, it is not uncommon to have a residential offering with an income producing component. Examples would be rental units on a larger parcel, a grove or orchard producing income, or horse properties, to name a few. In these cases, value can be calculated as a function of income on part of the purchase price. This is the primary method in determining the value of commercial property. To illustrate how this works, imagine that you will be lending $10,000 to a friend at a rate of 5% interest. Your rate of return on your “investment” is 5%, or $500 of income annually. Your return is referred to as your capitalization rate of return on your investment property, or “cap rate.”

The way in which a cap rate would be used to find a range of value is to research the sales of similar income producing situations. If an avocado grove, for example, sold for $200,000, and the net income after all expenses over a period of three years averaged $10,000, the rate of return on the investment was 5% ($10,000/$200,000 = .05). If we know that avocado groves averaged a 5% capitalization rate, and the grove which we want to value produced an average of $5,000 net annual income during the past 3 years, we can determine that the value of our grove is in the range of $100,000 ($5,000/.05 = $100,000). If we did not know the income, but did know the sales price, then we could establish the income using a little algebra ($100,000 sales price *.05 cap rate = $5,000 income).  The valuation process is the same for residential rental or any other like-kind income producing properties.

Of course, there are many other factors influencing value which reach beyond the common methods described above. Among those other factors are the entitlements and encumbrances that run with the property. An entitlement is a right that benefits the property, such as an easement across a neighbor’s private property for the purpose of traveling to and from your property. An encumbrance is some form of restriction that limits your property in some way, such as a mortgage.

Staying with the example of an easement, suppose that a particular property you wanted to purchase was located a short distance off of a County of San Diego maintained road crossing three private parcels of land before accessing the parcel you are eyeballing. The parcel is listed for sale for $100,000.00 with no mention of whether the parcel comes with legal access. A typical buyer would then assume the parcel does have legal access – what is referred to in real estate vernacular as an appurtenant easement – and negotiates a sales price of $90,000.00. During the inspection period, or due diligence period as it is referred to in the real estate business, it is discovered that the parcel does not have a legal access entitlement. This information would appear as an exception in the title report – and is easily overlooked unless one is actually reading through the tome of boilerplate ambiguous and confusing language used by title companies. This means that, should any of the owners of the private property between the public road and the parcel for sale should block the access, you will not be able to legally access the property.

Fortunately, California law provides for a remedy to being landlocked by private property. Both remedies involve litigation. Suing for access when there has been unobstructed, open and notorious use along a specific route for more than 5 years is the process for perfecting an implied easement through prescription. If the elements for prescriptive access are not present, the legal process for obtaining access would be under the law for easement by necessity. In either case, the litigation costs could be substantial and should be offset against the sales price, thus diminishing the value of the parcel under consideration.

Continuing the story about the $100,000 landlocked parcel, this same parcel has a spring; an artesian water source for a large pond. The pond overflows and provides water to a neighbor’s pond two parcels away from the subject property. When the preliminary report of title is delivered, you notice an entry on the list of exceptions referencing a recorded water entitlement document naming a particular person and a string of incomprehensible measurements describing a parcel of land. This encumbrance ‘burdens’ the property you are eyeballing and gives the benefiting party the right, or entitlement, to access the water in accordance to the terms of the recorded document.

An example of a common encumbrance is a deed of trust recorded against the title of a property securing a promissory note evidencing a debt. The notable difference between the deed of trust encumbrance and the water right encumbrance described above is that the water right encumbrance is said to “run with the land” while the deed of trust can be removed by the burdened party by paying off the debt and recording a reconveyance deed.

Of the two encumbrances described above, only the water right encumbrance is likely to have a deleterious effect on the value of the subject property, since the water right encumbrance can only be removed by the benefiting party. With respect to value, the question is, how much more valuable would the parcel be if a neighbor did not have entitlement to the water source? Or, how much would the purchaser be willing to pay to the burdening party to remove the encumbrance?

Property Valuation Part 3