How exactly does an appraiser come up with a value for residential or commercial property? First, an appraiser looks at a property from several different approaches to arrive at his value.
The basic property approaches are the Sales Comparison Approach, the Cost-depreciation Approach and the Income Approach.
The approach an appraiser chooses will depends upon property type and sometimes function. For example, if the subject property is a residential home to be purchased as a primary residence, he will probably not be able to use an income approach because the home will not have income related.
On the other hand, if an appraiser is looking to find the value of a rental property that has income, he may be able to use all three approaches if there are similar properties currently on the market or that have been sold in the last twelve months. Everyone should understand how value is determined by an appraiser and the approaches used so that we understand how they arrive at a price. Sometimes knowing these things can also give us ideas on what to improve with our property.
Sales Comparison Approach (also called Market Data Approach)
This approach is used for appraising residential property or vacant land. It compares the subject property to similar properties and makes adjustments on the basis of the physical features and/or the amenities and the date of the sale in that location.
The sales comparison approach is based on the principle of value called substitution, which says a buyer will “substitute” one property for another if other properties similar exist.
For example: Mr. O’Brien, a buyer, is looking for a three bedroom, two bath ranch with ¼ acre lot. He goes to a subdivision where all the properties feature ¼ acre lots. He finds ranches, splits and two story homes, but he remains interested in ranches only. Mr. O’Brien is given a CMA (Comparative Market Analysis) by the real estate agent he is working with that shows all of the features of these three properties.
Mr. O’Brien makes an offer on one of the properties, and it is accepted by the seller. Mr. O’Brien’s lender hires an appraiser to establish the value of the property. The appraiser will compare the property (Principle of Substitution) that O’Brien wants to buy with other properties that have sold recently and those that are currently on the market to establish value for the bank.
An appraiser gathers the data and works with the data to reconcile any differences to find the value of the subject home.
Example: The appraiser finds a property which has sold located in the same neighborhood, and wants to use it as a comparable sale. The comparable has more bedrooms than the subject, one less bath, and one less garage. The appraiser will have to subtract the extra bedrooms, from the comparable sold price, add a bathroom to the comparable sold price, and add a garage to the comparable sold price to make the properties equal.
Cost Approach (also called Summation Approach)
This approach is used on buildings which do not have market data because they are unusual properties (school, post office, library, etc.) or buildings without income.
Reproduction cost: To replace with the same materials as original construction (most costly). Example: Historical building would usually be restored using the original materials as much as possible.
Replacement cost: To replace with current materials and methods with utility and function similar to original. Example: If a normal house burned, it would be rebuilt using materials and standards to current code.
Steps involved in the Cost Approach:
Estimate the value of the land by itself, as if vacant. Then we need to determine either the replacement or reproduction costs of the building. From there we deduct all accrued depreciation from the replacement cost and add the estimated land value to the depreciated replacement or reproduction cost.
Depreciation: A loss in value due to any cause; any condition that adversely affects the value of an improvement.
This approach is used for income generating properties, such as apartments, retail centers, multi-tenant office buildings, etc.
Estimate annual potential gross income and then subtract an allowance for vacancy and collection losses to arrive at an effective gross income (EGI). Deduct operating expenses. (These do NOT include debt service or mortgage payments.) This is Net Operating Income (NOI). Operating expenses can be fixed (the same every month), variable (such as the cost of water or air conditioning) and the reserve for replacements (a certain amount “put away for a rainy day.”) Mortgage payments are not considered as operating expenses in figuring the NOI on a property because they would be different depending upon down payment and several other factors.
Then the appraiser will estimate the price a typical investor would pay for the income produced by this particular class and type of property. This is accomplished by estimating the rate of return that an investor would demand for this investment, based on current market conditions. This rate of return is called the Capitalization (Cap) Rate. Cap rate can also be considered the risk factor in buying a property. The higher the risk (Cap Rate), the lower the sale price should be.
The Cap Rate is applied using this formula: Net Operating Income divided by Capitalization Rate = Value