If you ever plan on buying or selling a piece of real estate in your life, whether residential or otherwise, you’ll come into contact with one of these types of real estate appraisals. Almost the entire transaction depends on the results of an appraisal at various stages. Perhaps both the buyer and the seller are happy with the agreed contract price. However, that doesn’t mean that the lender, insurer, etc. will be.
An appraisal presents all parties involved with an unbiased, calculated value for the home. This value takes into account certain conditions and circumstances. Most of us are familiar with the concept of an appraisal. However, many don’t know that there are a few types of real estate appraisals, called “approaches”.
While each approach tries to come up with an unbiased property value, they are unique. Each approach uses its own variables, scope, and methodology to come up with an answer. They also have their own pros and cons. As we’ll see, some are better or worse for certain types of properties or transactions.
Why do these types of real estate appraisals matter?
We will look at what makes each specific type of appraisal important in the relevant section. However, there are some reasons why ALL appraisals matter for one reason or another:
- An unbiased assessment of the home’s value: Everyone involved in the sale of a home has a stake in its value. The buyer wants the value to be as high as possible. The seller wants it to be as low as possible. And the real estate agent might have a commission hanging in the balance. Under the Home Valuation Code of Conduct bill, appraisers are even more independent than before. This results in accurate and unbiased assessments that are harder to refute.
- It’s a make-or-break factor for lenders: The bottom line for a lender when it comes to a mortgage is the home appraisal value. In most cases, a mortgage is the only way for a buyer to afford a property. This means the appraisal determines the fate of the entire transaction. If the appraisal is too low, the loan probably won’t be approved, leaving all parties high and dry.
- Insurance: Insurers base their decisions on an appraisal process. They also use it to determine how much the value of the home has changed with any additions, upgrades, etc. An appraisal indicates how much you can insure your home and its contents.
“Cost approach” real estate appraisals
Once you know how a cost appraisal works, the name is pretty self-explanatory. In its most basic form, a cost appraisal is when you try to establish exactly what the cost would be to create exactly the same property right now. This means that you take the value of the land and add the cost of construction to build exactly the same home or structure. Finally, you need to factor in depreciation to account for the home’s age.
This approach could be summed up with the question: “What would it cost to construct the exact same property right now, instead of buying it?”
There are two main branches of the cost approach appraisal. The reproduction method works on the basis of replicating the home exactly in terms of quality, building materials, etc. On the other hand, the replacement method works on an assumption that the replication uses modern techniques and materials.
Some of the factors that affect the accuracy of a cost approach real estate appraisal are:
- Age of the property: After reaching an initial total cost approach value, the appraiser will adjust the price according to depreciation since it’s not, in fact, a new property. The older the home, the bigger the influence of depreciation on the price. This lowers the accuracy of the appraisal.
- Similar plots of land: To build the same property, you’d need to buy a new lot of land. If there are no equivalent plots of land in the area, the appraiser must estimate the price of the land.
- Construction: If the home was constructed using outdated or unique methods and materials, it can be hard to accurately come up with a cost to replicate it.
- Improvements: As this appraisal method looks at the exact cost to replicate the property in question, it’s an accurate approach if the property stands out in its area regarding improvements or upgrades (or lack thereof).
Why it matters
- Insurance: Insurance companies use the cost approach method to evaluate a property. It’s one of the best methods to isolate the cost of the land and improvements.
- Construction loans: The cost approach method is a major factor in acquiring a new construction loan because it will help determine the market value.
- Market conditions: Cost approach appraisals can give you a good perspective on market condition. If housing costs are much higher, it’s a sign of highly inflated prices. The opposite is true if the evaluation comes in overpriced.
- Special properties: A cost appraisal focuses narrowly on the property being appraised. Thus, it’s a great value indicator for properties that are unique and don’t necessarily generate income. However, this is also the reason why cost approach appraisals aren’t used as often. Instead, they’re best for real estate properties that have had a lot of upgrades or improvements.
“Sales comparison approach” real estate appraisals
This approach should be easy to pinpoint based on its name. Using this method, a property’s value is surmised by looking at the sales price of similar properties for sale in the same area or market. However, any individual features of a property are also taken into account to adjust the price and arrive at a suitable market value. As you might’ve guessed, this is the most used approach when evaluating residential real estate properties by real estate agents and other appraisers.
This approach could be summed up with the question: “What should the value of this property be when compared to other relevant properties for sale?”
By narrowing down the market, local real estate agents or appraisers can look at home characteristics that are prevalent in an area. This allows them to come up with a value that certain features add to a home. These might include its size, a carport, swimming pool, eaves, etc. The home being appraised is then compared to other homes with similar features. This back-and-forth weighing of features allows appraisers to come up with a value.
This is very easy for real estate agents to do as they usually have access to a MLS (Multiple Listings Service). This “bluebook” with homes and their market values allow them to cross-reference properties based on many criterions.
Not only features of the actual homes apply but local features such as train stations, noise pollution, attractions, etc. also have a significant effect. This means that all houses in a certain area will be weighed in the same way according to this common distinguishing feature.
There’s only really one factor that affects the accuracy of sales comparison real estate appraisals:
- Availability of similar properties: As this method is based almost entirely on looking at similar properties, it becomes much harder to be accurate if your home is completely isolated. These homes not only need to be similar in terms of geographic positioning, but also in terms of size, amenities, age, etc.
Why it matters
- Real estate sales: This method is most often used by real estate agents that buy or sell local properties. As local real estate agents usually have an expert grasp of the local market and its characteristics, it’s a natural choice. This means your house will certainly be evaluated at some stage using this method, whether you buy or sell. Other approaches may be used in conjunction under certain circumstances.
- Pricing your home to sell: Using this method, you could get a rough estimation of your home’s value without a professional appraisal or real estate agent. By looking at the listing price of similar homes to yours within the same area, you could get an idea of what to ask. Looking at homes in direct competition can help you sell your home quicker by undercutting the going rate.
“Income capitalization approach” real estate appraisals
If you’re looking to buy or sell a residential property, chances are that you don’t have to worry too much about this real estate appraisal approach. The income capitalization approach focuses on evaluating properties that will be used to generate income. An obvious example of this would be an apartment block or condominium. This appraisal approach adjusts the market value of the property to account for its capitalization rate on account of its income-generating potential.
This approach essentially seeks to answer the question: “What should the value of this property be in terms of the potential income it can create?”
The value of a property can be easily established with this approach by using a relatively simple calculation:
Income capitalization value = net operating income/capitalization rate
First, you’ll need to establish the market value of the property using other appraisal methods such as the two above. Let’s say it’s a flat $1 million. Then, you’ll need to establish what the yearly income will be. For example, if you have twenty rental units that each brings in $1,200 a month, then the operating income would be $288,000 for a year.
You then need to calculate all operating expenses such as utilities, staff salaries, etc. If this amounts to $40,000 then your net operating income per year is $248,000.
Your capitalization rate would then be 24.8%. The capitalization rate is basically the pace at which a property would pay itself off and become “profitable”. In this case, it would take roughly four years for the property to do that.
Using this rate, you can then calculate the appraisal value. This value is always slightly more than market value for a profitable property and less for a non-profitable property (according to projections).
An income appraisal might be one of the hardest values to accurately assess because there are so many variables involved:
- Market value: The income property value will be derived using the original market value and the capitalization rate. Thus, the appraisal will only be as accurate as the original market value. Usually, the comparison appraisal approach is used.
- Projections: We used a simplified method to calculate the income by assuming a stable tenancy, etc. However, in the real world, your utility costs and income might vary from time to time and due to unforeseen circumstances, making the appraisal inaccurate in hindsight.
Why it matters
- Loans: A lender will use the capitalization rate as well as the income approach appraisal to assess its risk. The loan term may extend far beyond the stage at which the company becomes profitable. The higher the capitalization rate, the less the risk of the venture failing and that they will be repaid.
- Rentals: If you want to buy a residential real estate property, this appraisal method will probably be used at some point to establish how good an opportunity it is.
Appraisal make the real estate industry go round!
Whether you like it or not, real estate appraisals often have the final say in any real estate transaction. The different types of appraisals help establish common ground in terms of a fair, market-value price. This assists all parties involved in a real estate transaction. And it’s also the one thing insurers and lenders base their decisions on.
As a buyer, preparing your home for an appraisal could help you get a great price for your home. As a seller, it can stop you from making a bad investment. Knowing the types of real estate appraisals is part of being an informed buyer or seller. This is just one of the things a professional real estate agent can help with when going through a real estate sale.