Real-Estate Appraisals
Appraisals are important to buyers, sellers, and real-estate lenders. Buyers want to know that the value of the property they are purchasing meets or exceeds the amount they are paying for it. Sellers use appraisals to make sure they don't price a property too low. Lenders depend on the results of a formal real-estate appraisal to help determine if they should lend money on a property. It tells them whether or not they are likely to sell the property in a reasonable length of time for at least the amount they are investing in it if you default on the loan and force them to take the property back.
The property being appraised is called the
Three types of appraisals are common in real-estate transactions — sales comparison, cost, and income capitalization. Often only one approach is used, but for some properties, it makes sense to look at value from different angles. Another option is to calculate the gross rent multiplier.
Most appraisers belong to real-estate multiple listing services, so they are able to quickly find sold properties to use as comparables. Since they don't show properties when they are for sale, appraisers often call listing agents for feedback about the condition of the comps they choose.
Sales Comparison Approach
The sales comparison approach develops an estimate of the subject property's market value by comparing it to similar properties that have recently sold in the area. The sold properties are called
The appraiser typically selects three sold properties to compare to the subject property, adjusting the components of the comps to make their features closely match the subject. For instance, a subject with an open deck could be compared to a comp with a screened deck. The appraiser would adjust the comp, taking away the value of the screening. After adjusting the sales price of all three comps, the appraiser has a good idea of the subject property's market value.
Cost Approach Appraisals
A cost approach appraisal is an opinion of the subject property's value that is determined by calculating how much it would cost to replace it. The appraiser estimates the value of the structures and other improvements to the property, then deducts an amount for depreciation — a lessening of value that occurs over time from general wear and tear or because elements of the structure are obsolete. The value of land is determined by using recent sales of similar sites. Depreciation does not apply to the land.
Cost approach appraisals are most suitable for newer properties because it's easier to estimate replacement costs for the materials and methods used in the structure. This approach is also useful for appraising unique properties, where comparables cannot be found.
Appraisers consider different types of depreciation:
Physical depreciation is caused by normal deterioration of the property.
An aging roof and peeling paint are both considered physical depreciation.
Functional obsolescence refers to aspects of the improvements that make the structure less desirable or less marketable. Outdated designs, such as homes with four bedrooms and only one bath, fall under this category.
External obsolescence is caused by elements that make a property less desirable but are out of the control of the owner. A neighborhood that has changed from residential to industrial is one example of external obsolescence.
Income Capitalization Approach
The income capitalization approach is used to place a value on property based on its income-producing capabilities. It is most commonly used to estimate the value of office and apartment buildings, retail stores, strip malls, shopping centers, and other similar rental real estate.
The appraiser uses the sales comparison approach to find similar properties in order to determine if the subject property's rental fees are higher, lower, or similar to typical market rents.
The appraiser calculates the subject property's annual gross income and then deducts a figure for the normal operating expenses, such as taxes, routine maintenance, management fees, pest inspection and control, vacancy allowances, insurance costs, and other expenses associated with operating the property. The appraiser might also include an amount that represents a reserve for major repairs.
Net income is determined next by subtracting the operating expenses from the total amount collected from tenants, called gross income. The appraiser inserts the investor's desired rate of return into a mathematical formula with the other elements to calculate value: value = net income / capitalization rate.
Gross annual income |
$100,000 |
Less expenses |
($33,000) |
Net annual income |
$67,000 |
Capitalization rate |
0.10 |
Estimated value |
$670,000 |
Gross Rent Multiplier
The value of single-family homes destined to be rentals is sometimes estimated by using a gross rent multiplier (GRM). The appraiser locates comparable properties and then divides their sales prices by a typical monthly rental fee.
For instance, let's say you have a property with a sales price of $100,000 that could be rented for $800 per month: $100,000 / $800 = 125 GRM.
The appraiser locates a series of comparables to develop an average GRM, then the formula is approached from a different angle. If he finds that the average GRM in the area is 120, and the subject property could be rented for $875 per month, the estimated value of the property is $105,000. Here's how it works: $875 per month × 120 GRM = $105,000 estimated value.
