Most people experience the real estate exercise called property appraisal at least once in their lives. Despite this exercise being so common and necessary, many people do not have a clear understanding of this concept. The appraisal is a method by which the fair value of a property is ascertained. Seller and buyer may settle on a price and sign the agreement, but they must abide by the value of the property certified by a professional called appraiser.
Understanding property appraisal
What is a property appraisal
Property appraising is an estimation of its value carried out by a professional who is trained and experienced to do it. It is a manual process where the appraiser minutely inspects the structure and the features of a property. He adds up the value of land and construction as well as all its features. He then compares this value with the sale figures of similar properties recently sold in the area. He then comes up with a value that he thinks is an accurate estimation of the market value of the property. This value is still an estimate as despite following scientific methodology, the value of a property declared by an appraiser is subjective in nature.
Why is it necessary to get an appraisal?
An appraisal is a real estate exercise that is very helpful to lenders providing a mortgage to buyers. They are putting in lots of money, trusting the borrower to repay it along with interest. In case of a default, sale of the property is the only way to recover their money. As such, property appraising becomes a very important tool in the hands of lenders to ascertain the real value of the property. They cannot go by the agreement signed between the seller and the buyer. If the owner has inflated the price and later the lender finds that the property is much less value, it can do nothing to recover the money given to the borrower.
An appraisal is also a very good exercise for buyers and sellers. Some sellers get aappraisal of their property done before putting up their property on the market as they get an idea of the real value of the same. For the buyer, appraisal comes as an eye opener in many cases. If they have signed an agreement with the owner and later it turns out that the property is valued significantly less, they have the right to move out of the deal or ask the seller to lower the price of the house.
In the cases of divorce, appraisals help in the correct division of the asset between the two spouses. In cities where property tax assessments are carried out, many homeowners go in for an appraisal of their property if they are displeased with a sharp increase in tax assessment.
Different methods of valuation of a property
Property appraising is an art, not a science or math where 2+2 is always equal to 4. You cannot add up costs of materials and construction to arrive at a value as there are many factors that must be considered when arriving at an estimation of a property. Appraisers must consider the micro and macro location of the property, its features, and how its value is impacted by the neighborhood and amenities available.
There are basically three methods of valuation of a property. These are sales comparison method, cost approach, and income approach. Each one has its own pros and cons and the method chosen by an appraiser is dependent upon the data available to him as well as peculiar circumstances of the property.
Sales Comparison approach
Also referred to as market data approach, this method of valuation of a property is the most popular method among appraisers. It is easily applicable to parcels of land as well as constructed homes and apartments. Most appraisers apply this method of valuation when finding the value of single-family homes. It is also an easy method of estimating the value of a property when data is available regarding sales figures of comparable properties sold in the area in recent months. As the name suggests, the appraiser simply compares the property in question with comparable properties in the neighborhood that have been sold recently. Sales figures of only those properties that are very similar to the property being evaluated are considered by the appraiser. Also, these properties must have been sold within a period of last one year to arrive at a realistic fair value of the property.
In this method of valuation, an appraiser considers 3-4 comparable. He knows that no two comparables are exactly alike. This is the reason he must study 3-4 comparables to arrive at a fair value of a property. To account for differences in these comparables, the appraiser makes some adjustments in their sale prices. These adjustments are based upon external factors influencing the price of the property. The most important of these external factors of course ifs the location of the property. It can be surprising to many, but location can make a huge difference in the sale price of a property.
Other factors that help the appraiser in the adjustment of the sale price of comparables are frontage or the space available in the front, the number of bedrooms, kitchens, and bathrooms, the condition of the property, and finally the interiors of the property. The age of the comparable property also plays an important role in adjustments made to its sale price.
Comparison approach also considers the circumstances of the seller as sometimes the owner is desperate to sell the property at any price. In fact, while the comparison approach looks simple to an outsider, only an appraiser knows how complex it is to get help in arriving at the fair value of a property. Also, the quality of the valuation results heavily depends on how truly comparable the properties are.
This is another common method of property appraising. This approach is based upon the concept that an investor should not spend more money into buying a property than it would take him to construct a similar property. As the name implies, the appraiser starts from a scratch and adds up the costs of the land, the materials used for construction, and the money spent on buying all the features and fixtures inside the property. He adds up these costs and then subtracts the amount that is wiped out from the value of the property because of depreciation to arrive at the fair value of the property.
The cost approach is more suitable for buildings that are constructed but not sold such as schools, churches, hospitals, and government offices. It is usually not used for single-family homes and other types of residential real estate. One easy way to estimate the cost of construction of a building is to find the cost of construction of 1 sq ft and then multiply it with the area of the building.
The appraiser needs to have a clear understanding of depreciation in the value of a property after its construction. There are three types of depreciation taken into account by the appraiser. First, physical deterioration of the structure of the building is visible and it is easy to calculate. The second type of deterioration is functional obsolescence. It is a known fact in real estate that features that are considered highly desirable at one point in time do not hold importance in the eyes of investors a few years down the line. The concept of one large bathroom and many bedrooms is no longer considered desirable. The last type of deterioration is economic obsolescence. If the infrastructure of the neighborhood has not kept pace with other parts of the city, the property suffers from this type of deterioration as it is no longer considered an attractive location by the investors.
The income approach
This is another popular method of valuation of a property used by appraisers when arriving at the value of a property. This is a very versatile approach that can be applied to all types of real estate. However, the condition that the building should be bringing income to the owner is foremost in the application of this method of valuation. Housing complexes, commercial buildings, and multifamily buildings providing rental income to the owner are best for the application of income capitalization approach. The appraiser considers the net rental income, net operating income and the return on investment to calculate the value of the property.
The appraiser calculates the gross annual income from a property. This is done by adding up the annual rental income of all the units in the property. Then the appraiser subtracts an amount based upon the vacancy rates of the property. This gives him the net annual income from the property. Then he subtracts the operating expenses form this figure to arrive at net operating income. Now the value of the property is calculated by considering the capitalization rate or the cap rate of the property.
Another way of arriving at the value of the property using income capitalization approach is using gross income multipliers. This method is mostly used in case of properties that were not initially purchased for income but ended up as rental properties. The appraiser first finds out the net annual income from the property. He then divides the sale price of the property with this annual rental income. This gives the appraiser gross income multiplier which helps in arriving at the fair market value of the property.
A more sophisticated way to apply the income valuation method is by running a Discounted Free Cash Flow analysis. The advantage here is that yearly cash flow projections can better take into account capital expenditures, vacancies and their timing than just capitalizing one normalized year of earnings.
Property appraisal from an Investor’s point of view
It is always a good thing to have a basic idea of valuation methods
If you are a landlord or a real estate investor, knowing the ins and outs of different property appraisal methods is not essential for you. However, it is vital for you to know these important methods of valuation. If you have the basic idea, you can easily arrive at a rough estimated value of a property. However, as each property is different and unique, determination of its market value may not be that easy for a novice. This is where the skills and experience of a professional appraiser come into the picture.
The appraiser needs to find the most suitable valuation method
The thing to remember for anyone reading this article is to understand that the three methods of valuation described above arrive at three different values of the same property. It is required of the appraiser to reconcile the results to have a figure that is accurate and closer to reality. Depending on the objective and the property, one of these three methods proves to be most suitable for determining the value of the property. In many cases, it is not uncommon for appraisers to take the average of three figures arrived by using three different property appraising methods. However, in reality, an average is never a good proxy for the true value of a property. An appraiser will have a view which method has the most explanatory power and should come closest to a true value of the property. Therefore, the appraiser must give his reasons for the melting of the three results to satisfy the lender or the person who ordered the appraisal.
It is the final line of the appraisal report that most people are interested in. They just want to know the figure given by the appraiser as this is what matters to them the most. However, it is important for an investor to go through the details of the report to get an understanding of the structure, the underlying assumptions and the condition of the property.
Take help from these useful financial templates
Property appraising is a thankless job that requires a deep understanding of the valuation process. To help appraisers, we have developed some high-quality financial model templates. These templates are equally beneficial for investors and other real estate professionals. These financial models not only help in arriving at an estimated value of a property but also help in arriving at the entry/exit points in any real estate project. By using these financial templates, anyone having industry knowledge can easily calculate investor metrics as well as the relevant financial ratios. The following are the links to these financial model templates.
The Residual Land Value Calculation model allows you to determine the value of a piece of land from a developer's point of view.
The Mini Storage Business Plan Templates provides a financial plan to start a mini storage business. Enter your expected rent roll and cost structure and calculate Project IRR, Investor IRR and required funding.
This financial model can be used to evaluate the financial feasibility of a real estate development project and present it in investor grade quality to your partners. There is everything in there which is needed…
A nice deal builder for valuing and analyzing apartment building cash flow.
The commercial real estate valuation model template can be used to quickly value a commercial property such as an office building, industrial site, logistics or storage or a retail building via DCF valuation.
The Hotel Valuation Financial Model provides a simple way to forecast the expected cash flows for a hotel investment and calculates the relevant investor metrics such as the IRR (levered and unlevered).