What are real estate appraisals and why are they important?

If you’ve ever purchased a property before you’ve either knowingly or unknowingly paid a $400 fee.  They’re required whenever you want to get a loan on your property – conventional loan, home equity line of credit (HELOC), or a mortgage refinance.

To be sure, real estate appraisals are not the same as comparative market analysis (CMA).  Listing agents use CMA’s to determine the ASKING PRICE of homes.

The goal of an appraisal is to determine the market value of the property.  If the property were to be sold right now on the market, what would it sell for?

3 Real Estate Appraisal Methods

 

1. Income method – this method is typically used to value income producing properties such as commercial real estate and apartment buildings.  The value of the property is based on the income generated and dividing by the capitalization rate (or cap rate).  If an apartment building has a net operating income (NOI) of $100,000 and the cap rate is 6% for these types of properties, the value of the building is ($100k / .06 =) $1.67M.  The cap rate is the effective interest rate used to value the property which has an inverse relationship with price (or value).  Generally speaking, real estate in prime locations command lower cap rates and therefore higher prices. A small reduction in NOI has an amplified affect on the value.

2. Replacement cost – just like it sounds this method values the property by the cost to replace it.  For residential real estate, an appraiser would calculate the value of the land and the cost to construct a similar home.  With this approach the tough piece of the pie lies in valuing the lot.  Many times the value of the lot is not readily available like they are for constructed homes.  This method works particularly well for new construction.

3. Comparable sales – by far the most used approach for residential real estate.  Essentially, you find similar homes that recently SOLD to serve as your “comparable” sales (or comps).  In this case, appraisers find homes that are similar to the subject property and then use dollar “adjustments” to account for unique differences.

For example:

  • Property A: 3 bed / 2 bath w/ two-car garage, 10,000sf lot (subject property)
  • Property B: 3 bed / 2 bath w/ three-car garage, 7,000sf lot (SOLD for $400,000)

To determine the value of Property A, you adjust upwards for the 3,000sf of extra space  (say, $7000) and adjust downwards for the one less garage (say, $2000).  The net effect of the adjustment would be +$5000 for a comparable value of $405,000 for Property A.

When appraising properties a few things need to be kept in mind:

  • Arms-length transaction – sometimes homes are sold off-market to a family member at less than market.  While this is a recent sale, it does not represent the MARKET value of the home.
  • Value-in-use – sometimes for specific properties they are valued higher, but only for the specific use.  For example, a world-renowned glassblower has a store in the middle of nowhere.  People fly out to from all over the world to visit his 10,000sf storefront.  That property could appraise for $1M.  But if it weren’t for that specific business for that specific owner, there’s no way that property would be worth that much.
  • Highest and best use -this means that the valuation is based on the optimum use for the land.  A little girl runs a lemonade stand in the heart of downtown Seattle on a undeveloped acre of land.  While she runs a profitable joint making $500 on weekends, a cap rate of 5% values the land at ($500 x 52 / .05 =) $520,000.  In this case, a better proxy for value would be comparable sales.

Appraisal Reports

At first glance appraisal reports look daunting.  Many times they come in legal sized paper and can be up to 20 pages containing details of the subject property, pictures, side-by-side comparisons and appraisal disclosures.  If an appraisal is done on your house you can ask for a report which usually includes:

  • Market evaluation – the appraiser’s general assessment of the local market.
  • Adverse conditions – any glaring issues that would influence the value of the property like a transformer or power line in the back yard.
  • Appraisal value and method used – the appraiser will determine the value and the appraisal method deemed most appropriate for the property.

Can Appraisals Be Wrong?

In short, yes.  While most appraisals are based on a more scientific approach, it is still based on assumptions.  The market price of a home is what it would sell for TODAY.  The same exact home that sold 30 days ago might not sell for the same price today.

Also, appraisals naturally have smoothing tendencies.  Again, you’re using historic prices to determine today’s prices.   This adds a tendency to trend to the mean.

Lastly, in some cases the property owner or agent may know more about the property and neighborhood than the appraiser.  In such cases, the appraiser needs to get educated and guidance for determining appropriate values.

Can Agents Appraise Properties?

In short, no.  Appraisers are licensed in the state and typically have a bachelors degree and most are required to have at least an associate’s degree.  The appraisal process is more scientific and does require more education.  However, a good agent should be able to get pretty close to the appraisal value.

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