What is a Real Estate Appraisal ?
A real estate appraisal is an opinion of value, typically the market value, of real property.
Types of Value
There are several types and definitions of value that can be addressed in a real estate appraisal. Listed below are the most common:
Market Value: Estimated amount a real property should attain, on the date of valuation, involving a willing seller and a willing buyer in an arms-length transaction after proper marketing and the parties to the transaction both acting knowledgeably, prudently, and with no compulsion.
Value-in-Use: The net present value (NPV) of a cash flow that an asset generates for a specific owner under a specific use. Value-in-use is the value to one particular user, and is usually below the market value of a property.
Investment Value: The value to one particular investor, and is usually higher than the market value of a property.
Insurable Value: The value of real property covered by an insurance policy. Typically the site value is not included.
Liquidation Value: May be analyzed as either a forced liquidation or an orderly liquidation and is a commonly sought standard of value in bankruptcy proceedings. It assumes a seller who is compelled to sell after an exposure period which is less than the normal market timeframe.
Three Approaches to Value
There are three approaches to value considered in a real estate appraisal, sales comparison approach, income approach and cost approach.
Depending on the property and data available the appraiser determines which approach or approaches are applicable for a particular property. For example the cost approach is not applicable when appraising vacant land, the income approach may not be necessary when a appraising a single family home in an area where the homes are typically owner occupied. The appraiser will determine which approaches to use to provide the client with an accurate estimate of value.
Sales Comparison Approach
The sales comparison approach is the most common approach used in appraising residential real estate and is based on the principle of substitution. This approach assumes a knowledgeable buyer will not pay more for a property than it would cost to purchase a comparable property. The approach assumes that a typical buyer will compare asking prices and seek to purchase the property that meets his or her wants and needs for the lowest cost.
In the sales comparison approach recent sales of similar properties (comparables) is compared to the subject property (property being appraised). The appraisal report incudes a grid with information of each comparable sale and the subject property. Since comparable sales are not typically identical to the subject property, adjustments are sometimes made for the following data including but not limited to the following, date of sale, location, style, construction, condition, bedrooms, bathrooms, living square footage, site size, car storage, etc. The main idea is to simulate the price that would have been paid if each comparable sale were identical to the subject property. If the subject has a superior feature a positive adjustment would be made to the comparable, if the subject has an inferior feature than a negative adjustment would be made to the comparable. Adjustments are always made to the comparables, never to the subject. By analyzing the adjusted sales prices of the comparables, the appraiser indicates an opinion of value based on one of the following, the average of the comparables adjusted sales price, the adjusted sales price of the most similar comparable or the median price of the adjusted sales prices of the comparables.
Cost Approach
The cost approach is the value of a property estimated by adding the site value and the (estimated depreciated value) of any improvements. The value of the improvements can be estimated in two ways (1) reproduction cost new less depreciation, (2) replacement cost new less depreciation.
(1) Reproduction refers to reproducing an exact replica.
(2) Replacement cost refers to the cost of building an improvement which has the same utility, but using modern design, workmanship and materials. In practice, appraisers use replacement cost and then deduct a factor for any functional disutility associated with the age of the subject property.
The cost approach is considered reliable when used on newer structures, but the method tends to become less reliable for older properties. The cost approach is generally used when appraising special use properties (churches, public buildings). This is due to the lack of comparables to use the sales comparison or income approaches.
Income Approach
The income approach is typically used to value investment properties (income producing properties) either residential (2-4 family properties, apartments, etc.) or commercial (office buildings, hotels, industrial properties, etc.).
When appraising an income producing property this approach analyzes the income into a value indicator.
When utilizing the income approach the appraiser will analyze the income generated by the subject property and comparable properties.
For residential properties the Gross Rent Multiplier (GRM) will be estimated by analyzing the comparable income properties. The GRM is determined for each comparable by dividing the sales price of each recent comparable sale by their monthly gross rents. The estimated monthly market rent of the subject will then be multiplied by the Gross Rent Multiplier to indicate a value based on the income approach.
For commercial and industrial properties the Capitalization Rate (Cap Rate) is used. The cap rate is a ratio used to estimate the value of income producing properties. The cap rate is the net operating income divided by the purchase price of a property expressed as a percentage. Appraisers, lenders and investors use the cap rate to estimate the value for different types of income producing properties. To determine the cap rate to use in the appraisal of a particular investment property the market cap rate is determined by evaluating the financial data of comparable properties which have recently sold. It provides a more reliable estimate of value than a Gross Rent Multiplier (GRM) as the cap rate calculation utilizes more of a property's financial details. The cap rate calculation incorporates a property's selling price, gross rents, non rental income, vacancy amount and operating expenses thus providing a more reliable estimate of value.