Types of Appraisals
There are three basic types of appraisals: Sales Comparison Approach, Cost Approach, and Income Capitalization Approach. It is also possiblefor an appraiser to combine two or more of these types for a more detailed appraisal. Some lenders require a blended appraisal to be sure that the value is the same using different approaches. If one approach shows a considerably higher value than another, it is cause for concern.
Sales Comparison Approach
This is the most common type of appraisal for residential properties. The appraiser uses the sold prices of recently sold properties (called comparables) to determine the value of the subject property. The appraiser usually chooses between three and five similar properties to compare to the subject property. None of these will be an exact match since every property has its own unique features.
When locating comparable properties, everything counts. Even in a condominium complex, where every unit is alike, there are minor differences that affect value. The location of the unit, the direction it faces, the view, the interior condition, and upgrades make it necessary to adjust for each comparable property, even if it is only slightly.
The appraiser will make adjustments for each comparable property to create a list of properties that are as equal as possible to each other. For example, a house with a fireplace could be compared to a house without a fireplace after an adjustment is made for the value of the fireplace. This adjustment may be greater in the colder areas of the country where a fireplace is expected and may be lesser in the warmer areas of the country where a fireplace is used more for decoration.
An appraiser photographs the subject property and each of the comparable properties and also provides a map showing the location of each property. The appraiser also creates a side-by-side comparison table listing the properties with their features. The table shows the adjustments for each line item and the total adjustments on the appraisal.
When using comparable properties, most of the adjustments will be relatively small. The amount of an adjustment varies from region to regionand among different appraisers. When an appraiser needs to make large adjustments to verify a price, it can be a red flag to the lender that there is something wrong with the price of the property.
Cost Approach
This type of appraisal is determined by calculating what it would cost to replace the house as it sits on the property today. The appraiser takes into account the land value and the cost of the improvements separately. Improvements include the house and any other structures, such as out buildings, a guesthouse, or a detached garage. He then places a depreciation value on the improvements to come up with a final value. Depreciation is traditionally not calculated on the value of the land; it is only calculated on the value of the improvements.
Many appraisers will combine the Sales Comparison Approach with the Cost Approach, especially in markets where there are very few comparable properties or where many of the properties are newer.
Depreciation is a lessening of the value of the improvements based on wear and tear, obsolescence of certain features, and age of the improvements. If the house was built before the out buildings, guesthouse, or garage, the depreciation may be factored differently for the different structures.
Income Capitalization Approach
This approach is rarely used for single-family homes. It is used more often for rental properties. If your home is in an area made up primarily of rentals, the income capitalization approach may be used or it may be used in conjunction with one or more of the other approaches. This calculation usually takes longer since the appraiser needs to determine what the average capitalization rate (CAP rate) is in your area before determining your value. They do this by taking the sale prices of similar homes that are also rentals and dividing them by the annual net rental income. This gives the appraiser the CAP rate.
For example: Assuming rents of $1,650 per month, less expenses of $150 per month, gives a total rental income of $1,500 per month (or $18,000 per year).
If the sales price of a comparable property is $240,000, that amount is divided by the $18,000 annual rental income to determine the CAP rate of 7.5 percent.
To determine the value of your property, an appraiser would divide your annual net rents by 7.5 percent.
For example: Assuming rents of $1,800 per month, less expenses of $135 per month, your total rental income is $1,665 per month (or $19,980 per year).
Taking the $19,980 and dividing it by the 7.5 percent CAP rate gives you a value of $266,400.
If a buyer is purchasing your home as an investment and has signed a lease with a tenant to commence at close of escrow or is taking over an existing lease, some lenders will count the rental income as part of the buyer's income. If this is the case, the lender may require the Income Capitalization Approach to be used as a part of the appraisal.
