Real Estate Appraisal

An appraisal is an independent estimate of the value of a parcel of real estate by an appraiser using standard and approved methods. In many states, appraisers are required to be licensed.

The appraisal report is a detailed listing of the appraisal that is usually done for the lender of the property, or by the owner, usually to establish a selling price. Most appraisal reports are based on preprinted forms, such as the Uniform Residential Appraisal Report, that comply with the Uniform Standards of Professional Appraisal Practice (USPAP) guidelines and are required by federal agencies that may be involved in the sale of the property, such as a federal bank lending money for the property.

The appraisal report

identifies the real property being appraised;
the date of the report;
its purpose and intended use;
the actual methods used to appraise the property, including methods that were not used;
assumptions and conditions that may affect the value of the property;
the best use of the real estate;
the estimate of the real estate’s value;
and it should show compliance with the USPAP guidelines.

The USPAP also requires that the appraiser sign the report as a method of certifying it.

However, since professional appraisals cost money, real estate agents generally do a competitive market analysis to establish a selling price for a home. A competitive market analysis (CMA) is the estimation of the value of a property by comparing it to similar properties in the same area that have been recently sold. A CMA is not as comprehensive or detailed as a formal appraisal, and also has a bias, since a CMA is usually done by a real estate agent for a property owner to determine the best selling price. A CMA should never be presented as an appraisal.

In certain special cases, such as in a divorce or estate proceeding, the bank or attorney handling the case may get a broker’s price opinion (BPO), in which a broker, for a fee, simply drives by the property, takes a picture of it, and fills out a BPO form to give to the bank or attorney.

Appraisal Process

The appraisal process evaluates all of the data that may affect the value of the property. The data can be classified broadly as general data such as the neighborhood, city, and region of the real estate, and as specific data, which is the information concerning the property itself.

Market Value, Market Price, and Market Cost

There are 3 different kinds of property value that are related, but not necessarily the same: market value, market price, and market cost.

The appraiser tries to accurately determine the market value of the real estate, which is the price that the property would probably sell for if the following characteristics are satisfied:

buyer and seller must be acting at arm’s length and without pressure;
buyer and seller are both well informed about the property, including its potential and defects;
and that the real estate is on the market for long enough so that a number of buyers become aware of it and learn about it.

The market value is deemed to be the most probable price at which the property will sell, not necessarily the average or the highest price. The market value is considered to be the cash price, so it does not take into consideration any financial incentives or financing arrangements.

The market price is the price that the property actually sells for—it may be more or less than the market value, particularly if either buyer or seller needs to complete the transaction quickly, or if the transaction is not at arm's length, such as a sale between relatives or friends.

Market cost is what it would actually cost to buy the land and build the structures. Market value and market cost may not be the same; it is rarely the same for improvements to the property. For example, paying $40,000 to add a new addition may not increase the market value by $40,000.

Methods to Determine Market Value

There are 3 general methods to actually determine market value:

the sales comparison,
the cost approach,
and the income approach.

Not every property’s market value can be determined by all 3 approaches; usually, there will be a best method, but the other methods may narrow the range of the estimated market value. Specific types of property will usually have the same best method.

Both the sales comparison approach and the cost approach are based on the economic principle of substitution—when 1 thing can be substituted for another, then their values will be comparable. Hence, the value of property will be comparable to either comparable properties with similar qualities or what it would cost to build an equivalent property from scratch.

Sales Comparison Approach

The sales comparison approach (aka market data approach) is a more sophisticated competitive market analysis, and is the main method for determining the value of single-family homes. The subject property is compared to recently sold comparable properties. However, because no 2 properties are exactly alike, the sales prices of the comparable properties must be adjusted up or down for each of the differences between the subject property and the comparable properties.

When comparing different properties, not only must the differences in the properties, such as the actual structures, its ages, and conditions be compared and accounted for, but also what property rights are being transferred or were transferred in the comparable properties, and also any differences in encumbrances must be considered.

For instance, is a fee simple title being transferred, or are there any easements or deed restrictions on the subject property or on the comparable properties?

Cost Approach

Generally, the cost approach considers what the land, devoid of any structures, would cost, then the cost of actually building the structures is added, and depreciation is subtracted. The cost approach is most often used for public buildings, such as schools and churches, because it is difficult to find recently sold comparable properties in the local market, and public buildings don’t earn income, so the income approach cannot be used, either.

The cost approach:

Estimate what the vacant property would be worth.
Estimate the current cost of building the structures, then add the value to the value of the vacant land.
Estimate the amount of accrued depreciation of the subject property, then subtract it from the total to arrive at the property’s worth.

There are 2 methods of estimating what it would cost to replace the structure:

The reproduction cost is the cost of duplicating the subject property’s structure completely.
The replacement cost is the cost of building a similar structure, but using modern construction methods and materials.

The replacement cost is the approach most often used because it uses the most modern materials and features, eliminating functional obsolescence, such as rooms of an undesirable size or high maintenance construction materials.

Estimating Reproduction or Replacement Cost

There are 3 major methods of estimating the reproduction or replacement cost:

The square-foot method (aka comparison method) takes the cost per square foot of a recently developed comparable property and multiplies it by the square footage, using the external dimensions of the structures of the subject property.
The unit-in-place method estimates the cost of the subject property by summing the costs of the individual components of the structures, such as materials, labor, overhead, and profit.
The quantity-survey method estimates the separate costs of construction materials, labor, and other factors and adds them together. This method is the most accurate and the most expensive method, and is mainly used for historical buildings.

There is also an index method that uses the actual construction cost of the subject property, then multiplies it by how much the cost of materials and labor have increased since the structure was built. This method is deemed the least accurate and is generally used as a check on the 3 main methods of reproduction or replacement cost.

Depreciation

In estimating property value using the cost approach, depreciation is subtracted from the total value. Depreciation as used in real estate appraisals has a slightly different meaning than in has in taxation. Depreciation is simply the loss of value due to all causes. In most cases, land does not depreciate, unless it is degraded by erosion, improper use, or perhaps zoning changes.

Depreciation is either curable or incurable. Curable depreciation is a loss of value that can be corrected at a cost less than the increase in property value that would result if it were corrected, whereas an incurable depreciation either cannot be corrected or would cost more than any appreciation of property value.

Depreciation can be classified according to its cause:

Physical deterioration is the deterioration of structures due to wear and tear.
Functional obsolescence is a loss of value associated with features that have been discounted by the market, such as unfashionable design features, outdated plumbing, electrical, or heating systems, or inadequate insulation.
External obsolescence is a loss of value caused by external factors, such as the surrounding property, environment, or other factors that may decreases the property value, such as the municipality in which the subject property is located.

Although the different types of depreciation can suggest improvements, it is difficult to calculate the actual amount, so a simplified straight-line method (aka economic age-life method) is used, that simply assumes that depreciation is linear over the lifespan of the structure, decreasing in value at a constant rate. The amount of annual depreciation is calculated by dividing the cost of the structures by their expected lifetime.

Example — Straight-Line Method of Depreciation

If a house that cost $250,000 with the land valued at $50,000 were expected to last 40 years, then the annual depreciation would be calculated thus:

Value of House = Property Price - Land Price = $250,000 - $50,000 = $200,000
Annual Depreciation = Value of House / Expected Lifetime of House = $200,000 / 40 = $5,000.

Income Approach

The income approach values property by the amount of income that it can potentially generate. Hence, this method is used for apartments, office buildings, malls, and other property that generates a regular income. The appraiser calculates the income according to the following steps:

Estimate the potential annual gross income by doing market studies to determine what the property could earn, which may not be the same as what it is currently earning.
The effective gross income is calculated by subtracting the vacancy rate and rent loss as estimated by the appraiser using market studies.
The net operating income (NOI) is then calculated by subtracting the annual operating expenses from the effective gross income. Annual operating expenses include real estate taxes, insurance, utilities, maintenance, repairs, advertising and management expenses. Management expenses are included even if the owner is going to manage it. The cost of capital items is not included, since it is not an operating expense. Hence, it does not include mortgage and interest, since this is a debt payment on a capital item.
Estimate the capitalization rate, which is the rate of return, or yield, that other investors of property are getting in the local market.

Effective Gross Income = Annual Gross Income - Vacancy Rate - Rent Loss

Net Operating Income = Effective Gross Income - Annual Operating Expenses

Capitalization Rate = Net Operating Income / Purchase Price or Property Value

Therefore:

Property Value = Net Operating Income / Capitalization Rate

Example — Determining the Best Value for your Investment

You are considering buying 4 condos for rental income for $200,000 total. You can rent the condos for $500 per month each to long-time tenants, and your total operating costs for each condo is $200 per month. Then:

Net Operating Income = $500 x 4 x 12 - $200 x 4 x 12 = $14,400
Capitalization Rate = $14,400 / $200,000 = 0.07 = 7%

As you can see, the capitalization rate is your rate of return on your investment and can be used to compare rental properties to other investments. For instance, if you can buy investment-grade bonds that pays 8%, then that would probably be a better use for your money, especially when you consider that you won't have to worry about finding new tenants or making repairs.

Gross Rent and Gross Income Multipliers

Another method of valuing properties is by the application of the gross rent or income multiplier, which is the simpler than the income approach described above.

The gross rent multiplier (GRM) is used to value residential properties with 1 to 4 units and is equal to the sales price divided by the monthly rent:

GRM = Sales Price / Monthly Rent

The appraiser does not, however, use the current rent being charged, but uses recent rental information from at least 4 comparable properties to arrive at a more accurate appraisal.

The gross income multiplier (GIM) is similar to the GRM, but is used to value commercial properties and residential properties with 5 or more units. The GIM includes all income rather than just rent and is calculated just like the GRM, but using all income instead of just rent, and can include income from concessions or other sources.

GIM = Sales Price / Total Income

Once the multiplier is found, then the value of the subject property can be estimated by multiplying the GRM or GIM by the monthly income.

Market Value = (GRM or GIM) x Monthly Income

Example — Determining Increase in Market Value by Gross Rent Multiplier

If you paid $120,000 for a house with 4 apartments that are rented for $500 per month each, then:

Total Monthly Income = $500 x 4 = $2,000
Gross Rent Multiplier = $120,000 / $2,000 = 60

If, after a few years, you raise the rent to $600 and still keep your tenants, then your property is worth:

Property Value = GRM x Monthly Income = 60 x $2,400 = $144,000.

Reconciliation

Reconciliation is the analysis of the 3 approaches to determine the final value to assign to the property. Because the different approaches are best for specific types of property, the best approach for the subject property type is given the greatest weighting, with some value adjustments from the other approaches if the appraiser deems that it is warranted.

The appraiser should explain the reasoning behind the reconciliation, especially how it relates to the current market.

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Information is provided 'as is' and solely for education, not for trading purposes or professional advice.

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