Real Estate Appraisal
Real estate appraisals are used by sellers, buyers, and their lenders. Sellers want to ensure that their sale price is not less than the property's worth. Buyers, and particularly their lenders, want to ensure that the property is worth at least the purchase price. Indeed, most real estate sales contracts provide a provision allowing the buyer to back out of the sales agreement without penalty if the real estate appraisal is less than the purchase price. Moreover, lenders will limit any loan amounts to buy the property to a percentage of its appraised market value, not its purchase price.
A real estate appraisal is an independent estimate of the value of a parcel of real estate by an appraiser using approved, standardized methods. In many states, appraisers are required to be licensed. However, appraisals are opinions and will vary with the appraiser.
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 (Uniform Residential Appraisal Report (Uniform 1004), Actual 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 realty 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) estimates property values by comparing it to similar, recently sold properties in the same area. A real estate agent will have personal knowledge of what has sold and for how much. A useful tool in generating the competitive market analysis is the Multiple Listing Service (MLS), a database shared by the real estate agencies showing properties listed for sale and also the selling price and date of the properties when they are sold, as well as aspects of each property that determine selling price, such as square footage, and the number of bathrooms and bedrooms. 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 substituted for an appraisal.
Because an appraisal determines value based on location, size, type of residential property, income, and gross features of the property, such as the number of bathrooms and bedrooms, it is not a substitute for a property inspection or a survey. Appraisers do not look for latent defects or verify property boundaries, for instance, which may have a large impact on the property value. An appraisal also does not determine good title, so it is no substitute for a title search.
In certain special cases, such as valuing estate property or properties involved in a short sale or foreclosure, a bank or attorney may request a broker's price opinion (BPO) as a substitute or as a preliminary assessment of value, in which a broker, for a fee, fills out a BPO form, comparing the property to similar properties based on information in the Multiple Listing Service (MLS), to estimate value. The broker or a real estate agent may also drive by the property to take pictures. A BPO is faster and cheaper than a formal appraisal. A BPO may also be requested if the property was recently appraised, but the lender or other interested party may want to determine if its value has changed significantly since the appraisal.
Computer-generated automated valuation models may also be used to estimate value, where accuracy is not paramount, such as for low risk home-equity loans, determining whether the borrower has the 20% equity in the home necessary to eliminate private mortgage insurance payments, and for portfolio analysis, when the value of many properties must be estimated, such as when mortgages based on the properties are being securitized into mortgage-backed securities.
The appraisal process evaluates all 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.
One general factor that is considered is the absorption rate for a neighborhood, which is the number of months it would take to sell the entire inventory of houses in the neighborhood. A value exceeding 6 months is indicative of oversupply and will lower the appraised value.
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
- market cost
The appraiser tries to accurately determine the market value of the real estate, the price the property would probably sell for if the following characteristics are satisfied:
- buyer and seller act at arm's length and without pressure;
- buyer and seller are both well informed about the property, including its potential and defects;
- the real estate is on the market long enough to attract some buyers.
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 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 probably will not increase the market value by $40,000.
Determining Market Value
There are 3 general methods to actually determine market value:
- sales comparison
- cost approach
- 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 to the 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. Important characteristics to compare include:
- location, especially if recently sold properties were in the same neighborhood
- considered features related to location include panoramic views from the property, the amount of street traffic and noise, whether the property is in a cul de sac, and whether it is adjacent to parks or recreational areas
- size of structures and lots
- sales prices within the last 6 months, with later prices carrying more weight
- physical features, such as a garage, pool, patios, porches, or decks
- condition of the property
- construction quality
- count of rooms, bedrooms, and bathrooms
- floor plan
- financing, since cash buyers may buy at lower prices while buyers using seller financing (often called owner will carry, or OWC, financing) tend to pay higher prices
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. Although properties that lack features of neighboring properties will be adjusted downward, properties with more expensive features that are not typical of neighboring houses will also be discounted. Appraisals for condominiums and apartments are often easier and more accurate because the units generally have the same features and floor plans, size, and age as others recently sold in the same complex.
When comparing different properties, not only must the differences in the properties, such as the actual structures, their 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?
Generally, the cost approach considers what the land, devoid of any structures, would cost, then adds the cost of actually building the structures, then 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 do not earn income, so the income approach cannot be used, either.
A property already improved will usually contribute some value to the site, but improvements can also lower the property value if the site's potential buyers wish to use the property for another use that would entail removing some of the improvements to the current site.
The cost approach is best used when improvements are new and there is adequate pricing information to value the property components. The cost approach may be less desirable if there are no recent sales of vacant land for which to compare, since the major method of valuing vacant lands is to use the sales comparison approach, or when construction costs are not readily available.
The cost approach method:
- Estimate what the vacant property would be worth.
- Estimate the current cost of building the structures, then add that 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 the 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. The replacement cost is also usually lower than the reproduction cost.
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 (wood, plaster, etc.), 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.
Vacant Land Appraisal
Vacant land is generally valued as if it were used for its best use, regardless of its present use, which is generally done by comparing it with other similar properties put to its best use. Vacant land can only be appraised using the sales comparison approach, since vacant land is not constructed nor does it earn an income. The determination of land value is necessary in both the cost approach and the sales approach to estimate depreciation, since land is not depreciable.
However, vacant land may have some minor improvements but still be considered unimproved properties. Unimproved urban properties may have a paved street, a pavement, and available water, sewer, and other services, but would still be considered unimproved if there are no buildings or other structures. Unimproved agricultural properties lack farmsteads or other buildings but they may have a perimeter fence, drainage tiles, levies, a stock pond, or other such improvements.
These land improvements are included in the valuation of the land — not as part of any structures on the site. Evaluation of rural land may be more refined, taking into consideration the type of vegetation on the land, i.e. meadow or woodland, whether the land is tillable or not, and the type of soil.
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 it has in taxation. Depreciation is simply the loss of value due to all causes. 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 (aka physical depreciation) is the deterioration of structures due to wear and tear.
- Functional obsolescence (aka functional depreciation) is a loss of value associated with features discounted by the market, such as unfashionable design features, outdated plumbing, electrical, or heating systems, or inadequate insulation.
- External obsolescence (aka external depreciation) is a loss of value caused by changes in external factors, such as changes in the surrounding property, environment, zoning, or other factors that may decrease the property value, such as increasing crime or a change in zoning.
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 was 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.
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 will manage it, since the owner incurs an opportunity cost by managing it herself. 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 (aka cap rate), which is the rate of return, or yield, that other investors of property are getting in the local market.
Effective Gross Income = Gross Income - Vacancy Rate - Rent Loss
Net Operating Income = Effective Gross Income - Operating Expenses
Capitalization Rate = Net Operating Income / Purchase Price or Property Value
Property Value = Net Operating Income / Capitalization Rate
The capitalization rate is equivalent to the interest rate for bonds or the E/P ratio for stocks: more desirable properties will have lower cap rates than less desirable properties, for the same reason that Treasuries have lower interest rates than junk bonds or high-growth companies have lower earnings-to-price ratios than companies that are not growing. The cap rate takes into account the growth potential of either the property or its income. In other words, investors will be willing to pay a higher price for a property in a desirable neighborhood than for a property earning the same amount of income in a ghetto.
Example: Determining the Best Value for your Investment by Calculating the Capitalization Rate
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. To calculate the net annual operating income, figure the net income per month, then multiply by 12:
- Net Annual Operating Income = [($500 × 4) - ($200 × 4)] × 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. However, also keep in mind that the resale value of the condos will increase at least at the inflation rate, whereas most other investments, such as those for bonds will not. Furthermore, as property prices increase, then you can raise rents, allowing you to earn a return on an increasing principal, thus giving you the same benefit as Treasury Inflation-Protected Securities (TIPS). Hence, with investment properties, you not only have a hedge against inflation, but you will also earn increasing amounts of money in the years to come. The only drawback to properties over securities and other investments is that the properties have to be managed, and you must deal with tenants.
Gross Rent and Gross Income Multipliers
Another method of valuing properties is by the application of the gross rent or income multiplier, which is simpler than the income approach described above.
The gross rent multiplier (GRM) is used to value residential properties with 1 to 4 units and equals the sales price divided by the monthly rent:
GRM = Sales Price / Monthly Rent
The appraiser does not, however, use the current rent being charged, since it may not be the market rent, but uses recent rental information from at least 4 comparable properties to arrive at a more accurate appraisal.
|Condominium at 123 Main Street
|Single-Family Home at 908 Hilltop Street
The annual gross income of a commercial property, including residential properties with 5 or more units, equals its annual income from rents, concessions, parking, vending machines, and other sources. Annual gross income is used to valuate commercial property, so it is natural to use the gross income multiplier (GIM), calculated like the GRM, but using annual gross income instead of monthly rents.
GIM = Sales Price / Annual Gross Income
|Annual Gross Income
|ABC Commercial Unity
|DEF Woodridge Complex
Once the multiplier is found, then the value of the subject property can be estimated:
Market Value of Residential Property = GRM × Monthly Income
Market Value of Commercial Property = GIM × Gross 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 × 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 × Monthly Income = 60 × $2,400 = $144,000.
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.
What a Real Estate Appraisal Is Not
Real estate appraisals are, at best, estimates of value, based on limited information. For instance, the sales comparison approach depends on easily identifiable characteristics of the property. The appraiser does not do a property inspection, so latent defects would not be considered. However, latent defects will decrease the value of the property to the extent of their repair cost. The boundaries of the property are not verified, which should be done by a surveyor. The title being transferred is assumed to be fee simple with no encroachments. Obviously, transferring lesser legal rights or property with encroachments will decrease the value.
Another thing to keep in mind is that appraisers base most of their comp sales on secondhand information, such as MLS listings and government information. The appraisers do not do a walk-through of the comparable properties. Their comparisons are based on recorded sale prices and the descriptions of the properties. Therefore, unrecorded details that may affect property value are not considered. Additionally, people vary widely in their negotiation skills in buying or selling property and appraisals of properties by different appraisers will also differ, so even recorded prices on comparable properties in comparable neighborhoods will differ.
Because properties are rarely alike, appraisers must add or subtract amounts that reflect advantages or disadvantages of the appraised property over comparable properties. Only the market value of the differences is considered, not their actual cost. For instance, if the appraised property has a swimming pool, but the comparable properties do not, then the market value of the swimming pool — not its cost — is either added or subtracted, depending on the desirability of swimming pools in the locality. Swimming pools are usually more desirable in hotter climates, and less desirable in colder climates. So an accurate real estate appraisal will also depend on accurately assessing the market value of the differences between the appraised property and comparable properties, which introduces another source of possible error.
The best that an appraiser can really do is to offer a range of possible values for the property.
Rules to Prevent Inflated Real Estate Appraisals
To prevent inflated real estate appraisals that helped to create the Great Recession of 2007 - 2009, new guidelines were issued by Fannie Mae and Freddie Mac, and their regulator, the Federal Housing Finance Authority, for mortgages they will accept. A new independent institution, the Independent Valuation Protection Institute, oversees the real estate appraisal industry to ensure that the industry is conforming to best practices.
These rules include:
- To reduce costs and maintain quality control, the guidelines allows lenders to continue using their own real estate appraisers, but there must be a firewall between the appraisers and the lenders, especially to prohibit lenders from setting price targets for the appraisals and not divulging how much the borrowers are seeking.
- Appraisals must be made according to the rules of the Home Valuation Code of Conduct, meaning, among other things, that mortgage brokers and real estate agents cannot order an appraisal directly, but must allow the lenders to use 3rd party appraisal management companies.
- Appraisers must include an extra market report of recent prices of homes selling in the local area and a projection of pricing trends. Appraisers are charging $45 - $50 extra for this report. Furthermore, many appraisers are requiring upfront payment for all appraisals with no refund if the mortgage application is rejected.
Independent Real Estate Appraisers
Part of the cause of the real estate bubble and the subprime debacle that occurred during the Great Recession has been overinflated home appraisals. Many lenders were using their own appraisal units, or subsidiaries or affiliated companies, to appraise properties at higher-than-market values to get loans approved. In the past, lenders would have been concerned about the risks, but, nowadays, with most mortgages being resold as mortgage-backed securities, the risks were being transferred to investors, which lessened the lenders' concern about risks and increased their focus on profits.
Starting in January, 2009, Fannie Mae and Freddie Mac, the largest buyers of mortgages that are securitized into mortgage-backed securities, will require that lenders use independent real estate appraisers. Also, real estate agents and mortgage brokers will not be allowed to select the appraiser.
Fannie Mae and Freddie Mac are creating an Independent Valuation Protection Institute that will promulgate rules to enforce independent and reliable appraisals, and will accept complaints from both consumers and appraisers as a way to monitor enforcement of the rules by the Office of Federal Housing Enterprise Oversight, the government regulator that oversees Fannie Mae and Freddie Mac.