Appraisal Review Manual 2015

3.1 Theories & Principles of Appraisal

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Sources: This article contains material from various sources. Among them: The Manual on Real Property
Appraisal and Assessment by DOF/BLGF; various other online articles on appraisal by several writers. It
also contains the editor’s own elaborate views and opinions.

A. General Concepts

In the Philippines, the professions involved in real property valuation are specified under R.A. 9646
(otherwise known as the RESA Law), and defined as follows –

 Real estate appraiser— performs or renders, services in estimating real estate values, such services
of which shall be finally rendered by the preparation of the report in acceptable written form.

 Real estate assessor — works in an LGU to perform appraisal and assessment of real properties,
including plants, equipment, and machinery, essentially for taxation purposes.

It would seem therefore that the practice of appraisal in our country means valuing “real estate.” However,
“real estate” is merely the physical manifestation of something owned or possessed. The real element that is
being valued by a real estate appraiser or assessor is not the real estate but the real property.

The term “Real Property” is defined by the IVSC as follows - “All rights, interests and benefits related to
the ownership of real estate.” Seen in this context, real property includes not only the tangible elements such
as real estate but also intangible forms of real property such as leasehold rights, franchise contracts,
easements, inheritance, etc.

Property is the inherent right of ownership and future benefits of tangible and intangible assets; any right or
interest reflecting a source or attribute of wealth. In the broad definition of IVSC, the term “Property”
includes real property (or also known as “realty”), personal property; businesses and financial interests.

Real property consists of rights in realty. Realty consists of land and all improvements, synonymous with real
estate. Personal property pertains to movable physical assets. Businesses are entities organized for profit
and they could own both realty and personal properties. Financial interests are shareholdings, securities, and
other monetary instruments.

The most common rights of ownership subjected to appraisal are those arising out of the ownership of real
estate. The IVSC defines “Real Estate” as follows: - “Land and all things that are a natural part of the
land, e.g. trees and minerals, things that have been attached to the land, e.g. buildings and site improvements,
all permanent building attachments, e.g. mechanical and electrical plant providing services to a building,
that are both below and above the ground.”

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The 'Bundle Of Rights'

Since value is measured in terms of “rights, interests and benefits”, it is important to recall the nature of
ownership of real property, the so-called bundle of rights. The “Bundle of Rights” is a long-standing concept
of ownership in real estate. It is a set of legal rights afforded to the real estate title holder. The bundle of
rights can include the right of possession (the property is owned by the title holder), the right of use (the
owner controls the property's use), the right of exclusion (the holder can deny people access to the property),
the right of disposition (the holder can buy or sell the property), the right of enjoyment (the holder can use
the property in any legal manner) and the right to recover its fruits. P+U+E+D+E +Rf.

Distinction between “valuation” and “appraisal.”

The term valuation is used in a general way. It means to make an estimate of value. The term appraisal is
almost synonymous. Appraisal also means making an estimate of value but this term is more commonly
encountered in statutes together the term “assessment.” A senior appraiser explains it like this --

“In connection with real estate, each property is appraised by the county government, and the property taxes are
based on this value; this determination is always referred to as an "assessment" and the value is the "assessed value".
The estimate of a property's true market value would be called a valuation to distinguish it from the assessed
(appraised) value; the assessed value is not necessarily a very good estimate of the current market value.

Thus the real estate agent would speak of the appraisal and the assessed value, and the market value estimated by
a valuation. But this differentiation between appraisal and valuation is specific to situations of tax assessment; in most
cases they are interchangeable.”

B. Concepts of Value

The term “Value” means – what a thing is worth.

Value is created by “utility,” – the capacity to satisfy the needs and wants of human societies. Contributing to
its value are a property’s uniqueness, durability, potential, features of location, relatively limited supply, and
the specific usefulness of a given site. The value of real property depends on the extent of the holder’s rights
or interests. In appraisal, it is necessary to identify what rights, or what part of the total bundle, are appraised,
i.e., which property rights are to be appraised.

Market Value

Value exists if property has utility, is relatively scarce, arouses the desire of potential buyer to buy and is
backed by purchasing power. There are many types of value. For real estate appraisal the most common type
of value is market value. There are two similar definitions of “Market Value.”

IVSC:
Market Value - The estimated amount for which an asset or liability should exchange on the valuation date
between a willing buyer and a willing seller in an arm’s length transaction, after proper marketing and where
the parties had each acted knowledgeably, prudently and without compulsion. (“Arm’s length transaction”
means a transaction between independent, unrelated parties involving no irregularity.)

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MRPAAO:
Market Value – is the price agreed upon by the buyer and seller in the open market in the usual and ordinary
course of legal trade and competition; the price and value of the article established or shown by sale, public or
private, in the ordinary way of business; the fair value of property is between one who desires to purchase and
one who desires to sell; the current price; the general or ordinary price for which property may be sold in that
locality.

Other Types of Value

Besides “Market Value”, there can be other types of value, depending on the intended use. Most of these
other types of value are called “Non-market values” because they do not reflect fair value obtained from the
free market.

According to the IVSC, the circumstances during which non-market values occur are when –

1) A thing is valued primarily for the benefit that an owner inherently enjoys;
For example: The value of a church as a place of solace and worship can not be derived from market
conditions. It is inherent in this type of property.

2) The reasonable price agreed is between two specific parties only;

For example: A price for a building is agreed upon between the company and another company which are
both subsidiaries of the same holding or parent company. There being no arms-length relationship, this value
could be influenced by other special considerations during negotiations.

3) Value determined by statute or contract. Examples of this abound – zonal values prepared by the BIR
are fixed (Revenue Regulations made by the CIR/DOF) or fair market values prepared by the LGU are fixed
(SFMV enacted by ordinance).

Many types of values are derived from market values and adjusted for special purposes such as – Insurable
value, Investment value, Asset exchange value, Going concern value, Liquidation value, Residual value,
Reversion value, Salvage value, Special value, Synergistic Value, etc..

 Asset exchange value – a value given to a physical asset when it is to be exchanged for other
physical assets or financial instruments.

 Going Concern - A business enterprise that is expected to continue operations for the foreseeable
future. Any future economic benefit arising from a business, an interest in a business or from the use
of a group of assets which is not separable.

 Liquidation Value - The net amount that would be realized if a business is discontinued and its
assets are sold individually.  The appropriate bases of value and any appropriate additional qualifying
assumptions should also be stated.

 Residual Value –

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1.   The anticipated value of an asset at the expiration of its useful life.
2.  IFRS definition (IAS16): “The estimated amount that an entity would currently obtain from
disposal of an asset, after deducting the estimated costs of disposal, if the asset were already of the
age and in the condition expected at the end of its useful life.” The application of the IFRS definition
is described in IVS 300 Valuations for Financial Reporting.

 Reversionary Value - The estimated value of an investment property at the end of a period during
which the rental income is either above or below the market rent. 

 Salvage Value - The value of an asset that has reached the end of its economic life for the purpose it
was made. The asset may still have value for an alternative use or for recycling.

 Special Value - An amount that reflects particular attributes of an asset that are only of value to a
special purchaser.

 Synergistic Value - An additional element of value created by the combination of two or more
interests where the value of the combined interest is worth more than the sum of the original
interests. 

Factors of Value: (DUST)

First and foremost, any real estate property has inherent value because of its unique characteristics. Such a
property exhibits certain basic factors of value –

1) Demand (desire and purchasing power) – satisfy buyer’s desires within their purchasing power;
2) Utility (product) – the product’s features that meet buyer’s needs;
3) Scarcity (supply) – less supply gives higher value;
4) Transferability (supply) – transfer of use, occupants, ownership, or liquidity; easy to resell.

Forces Influencing Value (PEGS)

Values in real estate are constantly changing. This is due to outside or external forces which may be
categorized into four:

1) Physical or Environmental Forces

a. Climate; b. Soil fertility; c. Mineral resources; d. Community factors – transportation, proximity of schools,
churches, parks and recreation areas; e. Flood control and soil conservation; f. Soil characteristics (subsoil)

2) Economic Forces
a. Natural resources- quantity, quality, location, rate of depletion; b. Commercial and industrial trends; c.
Employment trends and wage levels; d. Availability of money and credit; e. Price level interest rates, tax
burdens; f. Other factors affecting purchasing power

3) Governmental or Political Forces

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a. Zoning Laws; b. Building Codes; c. Police and fire regulations; d. Rent controls, special use permits, credit
control; e. Government sponsored housing and guaranteed mortgage loans; f. Monetary policies affecting free
use of real estate including taxation

4) Social Forces
a. Population growth and decline; b. Shift in population density; c. Changes in family size; d. Attitudes
toward education and social activities; e. Attitudes toward architectural design and utility; f. Other factors
emerging from human social instincts, ideas and yearning

C. Principles Relating to the Market Value

In order to better understand the theories of valuation, it is vital to recognize basic principles that have been
observed at play in a free market economy. Valuers have defined them as follows --

1. Principle of Supply and Demand – value is determined by the interaction of the forces of supply and
demand in the appropriate market as of the date of appraisal.

2. Principle of Highest and Best Use – it is the use from among all reasonable, probable, and legal uses that
is found to be physically possible, appropriately justified, and financially feasible and which results in the
maximum property value.

3. Principle of Substitution – states that a prudent purchaser would pay no more for a property than the cost
of acquiring an equally desirable substitute in the market. Substitution may take the form of:
acquiring an existing property with the same utility (basis for the market approach), or producing a substitute
property with the same utility (basis for the cost approach), or acquiring investment which will produce an
income stream of the same size with the same risk (basis for the income approach)

4. Principle of Contribution – the value of an agent in production or a component of a property depends on

how much it contributes to the whole, or how much its absence detracts from the value of the whole.

5. Principle of Competition – holds that profit tends to breed competition and excess profit tends to ruinous
competition.

6. Principle of Increasing and Decreasing Returns – when successive increments of one or more factors in
production are added to a fixed amount of the factors, there is a resulting enhancement in income up to a point
of maximum returns. Any incremental addition thereafter results in a diminishment of income.

7. Principle of Balance - balance among the factors of production is achieved at the point of diminishing
returns, which is the point of maximum value.

8. Principle of Change – change is inevitable and constantly occurring

9. Principle of Anticipation – value is created by the expectations of benefits to be derived in the future.
Value is dependent on the future, not the past: Past experience is useful for indications of future trends and
conditions that it may provide.

10. Principle of Conformity – maximum value is realized when a reasonable degree of homogeneity and
compatibility is present. Over improvement, under improvement or misplaced improvement may be
reasonable for non-conformity within a property or its environment. This principle works in conjunction with:

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

11) Principle of Consistent Use – both land and improvements are valued assuming the same HABU.

12) Principle of Externalities – external forces affect value: social, economic, physical environment, and
government;

13) Principle of Economies of scale – the greater the volume, the less the incremental cost for additional
volume;

14) Principle of Surplus productivity : 4 factors of productivity paid in this order – Labor, capital,
entrepreneurship, land + improvements (residual value)

15) Principle of Bite-Sizing – smaller portions, can be priced higher per unit of measure, but may be more
affordable to Pinoy buyers. Pinoy buyers tend to buy in “tingi” or small portions, especially with respect to
real estate.

D. Introduction to the Approaches to Value.

There are three commonly used approaches in valuation –

1. Market Data Approach;

2. Cost Approach; and
3. Income Approach.

They are briefly introduced and explained below. Each of these approaches require the use of methodologies
or analytical techniques. The detailed explanation of these approaches and methodologies are covered by a
separate chapters in this Manual.

1. The Market Data Approach

The “Market Data” approach is also called the “Sales Comparison” approach. They are synonymous. The
Market Data approach is useful when there is an active market with sufficient quantities of reliable data which
are verifiable by authoritative sources, otherwise it is unreliable. Information should include age, size
location and other factors pertinent to a comparison with a property exchanging in the market.

Market analysis may be made on a direct or comparative basis. Direct matching - property with an identical or
nearly identical property; Comparable matching - property with a similar property.

After market data have been accumulated, adjustments must be made on the indicated selling prices for
differences in physical characteristics, market condition and terms of sale. An adjustment is an amount which
is added to or subtracted from the selling price of a comparable property to reflect the value of differences
identified between the comparative property and the subject property.

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Because valuation depends on market transactions, it is obvious that the principles of “Substitution”,
“Change” and “Competition” are at work. The Market Data approach is used mostly for valuing land and not
very useful for valuing improvements because of the lack of comparables.

2. The Cost Approach

For valuing property improvements, where market data is insufficient or unreliable, the valuer can derive his
own cost estimate of the property. The starting point of the cost approach is the assembly of property facts
and cost data. These are combined in the cost estimating process to develop a reproduction cost new (RCN) or
cost of replacement (COR).

Reproduction Cost New (RCN) - cost of producing or constructing the property in like kind at current
prices… same materials, standards, design, and quality; a replica..
Cost of Replacement (COR - cost of producing or constructing a property of equivalent utility at current
prices…

After the RCN or COR is obtained, an amount or factor called “Depreciation” must be considered. This is
because the replacement cost estimate is that for a brand new improvement while the subject property for
valuation could be of a certain age.

The estimate of fair market value by the cost approach is summarized as follows:

Current Reproduction Cost New or Cost of Replacement

Less: Physical Deterioration: Curable and Incurable
Less: Functional Obsolescence
Less: Economic Obsolescence; Generally Incurable
Plus: Value of Land
Results in: Indicated Fair Market Value

Accountants will usually ask: Why not use the book value of the improvement? The obvious answer is that
doing so will not yield a market value. The acquisition cost of years ago is no longer representative of
today’s value because of inflation. Thus the starting point for market valuation must be the replacement cost
new.

C. The Income Approach

In this approach, an estimate is made of the prospective economic benefits of ownership. This approach is
predicated on the proposition that an informed purchaser would pay no more for a property than the cost of
obtaining an income stream of the same size and embodying the same risk as that involved in the subject
property. Principles of substitution and anticipation apply.

The income approach is particularly applicable when the future benefits of ownership may reasonably be
estimated in the light of related risks to be incurred. The approaches selected must be supported by the facts
and circumstances of the case on hand. The applicability of any approach in a given valuation problem
depends on the character of the problem, the type of the property involve, the nature of the market and, of
course, the availability of the required data of appropriate quality and in sufficient quantity.

1. Steps involved in translating the net income projection into a value indication

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a. Estimate potential gross income;

b. Estimate and deduct a vacancy and collection loss allowance to derive the effective gross income;
c. Estimate and deduct expenses of operation to derive net operating income (before debt burden);
d. Estimate remaining economic life of the duration and pattern of the projection income stream;
e. Select an applicable capitalization method and technique; develop the appropriate rate or rates;
f. Complete the necessary computations.

2. Capitalization Process

a. Capitalization defined – Capitalization is the mathematical process that translates or converts net income
into an indication of value.
b. The formula to derive capital value is: V = I / R; where V = value; I = net income; R = cap rate.

Reconciliation of the Three Approaches to Value

Reconciliation is the final step in estimating value. It is the process of relating the data gathered, developing
the three standard approaches to value, analyzing and weighing the strengths and weaknesses of each
approach, and determining which approach is best supported. Ultimately, the most relied upon approach will
be the most dependable.

E. Introduction to Real Estate Market Analysis Concepts

In the Market Data approach to valuation, the valuer may need to make a market analysis. This is usually
necessary for large projects or in mass appraisal assignments of assessors. A few important concepts are
introduced below. The initial step in market analysis is to identify the coverage or size of the market to be
analyzed. The market size could either be contained in the following –

Groupings of properties
1) Zones or district – group of homogenous land uses – residential subdivision, industrial zones;
2) Neighborhood – a group of complementary land uses. Community facilities + residential subdivision
lots. “Linkage” – connecting complementary uses to homogenous land uses.

After deciding on the market size, then it is necessary to examine the community and identify at what stage of
its economic life the entire area has reached –

The 4 life cycle stages of a community are

1) Growth; 2) Stability; 3) Decline; 4) Revitalization.

Market analysis can be simple or complex, depending on coverage and expected output. The three types of
market analysis are:

The 3 Types of Market Analysis:

1) Market study – not site specific; general study of the market, buyers, sellers, tenants..
2) Marketability study – relates to a specific product within a defined market; both site specific and
property type specific; studies absorption time, pricing levels.
3) Feasibility study – comparison of cost vs value; cost feasibility is part of HABU.

EXERCISES

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Q. The fundamental scope of a valuation assignment given to an appraiser consists of –

A. Making a listing of the real estate properties of the client in order to present it to potential buyers;
B. Defining and estimating the value of the rights and interest of a client over some realty
C. Evaluating the physical condition of a property in order to prepare the terms of reference for future repairs.
D. Determining the veracity of the title and all its related documents to prove rightful ownership.

Q. The Appraiser was requested to value an existing building on which there exists a long-term lease contract of
25 years with a foreign embassy because the Owner plans to sell the property. He can refuse the assignment for
the following reason –

A. Making a value estimate might prejudice the rights of existing long-term tenant.
B. The Client refused to divulge the commercial terms of the long-term lease to him because it is confidential.
C. It is impossible to predict the value of the property that is under an encumbrance such as a long-term lease.
D. The property may not be accessible for inspection because the lessee will not permit it.

Q. A building that is already 50 years old is no longer being used. It requires substantial restoration and
renovation work which the Owner no longer wants to undertake. The Appraiser is asked to value its –
A. Salvage value
B. Liquidation value
C. Residual value
D. Reversionary value

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

A. Real property
B. Intellectual property
C. Personal property
D. Businesses and financial interests

Q. An appraisal made for the purpose of determining a fair compensation for private property to be acquired
for use of the government.
A. Assessment appraisal
B. Expropriation appraisal
C. Foreclosure appraisal
D. Zonal value appraisal

Q. The value of a property which is inherent by its nature or its location and is not affected by external forces.
A. Synergistic value
B. Basic value
C. Inherent value
D. Sentimental value

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

Q. The principle which states that value will change due to the changes in supply and demand, time, and market
conditions.

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A. Principle of balance
B. Principle of anticipation
C. Law of supply and demand
D. Principle of change
E. Principle of conformity

Q. The value of a portion of the property when it provides a function that is as an indispensable component of the
entire property --
A. Competition
B. Highest and best use
C. Supply and demand
D. Principle of change
E. Principle of contribution

Q. Legally permissible, physically possible, financially feasible and maximally productive --

A. Competition
B. Highest and best use
C. Supply and demand
D. Principle of change
E. Principle of conformity

Q. Increasing the number of houses for production using precasting technology will reduce the unit cost of each
house due to the principle of --
A. Externalities
B. Economies of scale
C. Supply and demand
D. Increasing/diminishing return
E. Surplus of productivity

Q. Forces that affect the value of a property because of its poor location and irregular terrain --
A. Physical
B. Environmental
C. Government
D. Social

Q. An element of value not favorable to real estate products because of they are considered immovables.
A. Demand
B. Utility
C. Supply
D. Transferability

Q. Which is not part of the life cycle of a community –

A. Growth
B. Stability
C. Inflation
D. Decline
E. Revitalization

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