Property Appraisals: Common Methods
Updated: Sep 15, 2020
Understanding the true value of a property is critical for every real estate deal, and without this knowledge you will likely find yourself on the wrong side of many transactions. You need to know what the property is worth when you buy it, estimate what it will be worth at various stages in the future (refinancing, etc.), and calculate what it would be worth if you decide to sell. There are three methods an appraiser can use to determine this value. This article briefly touches on each one.
Comparable Sales Approach
How it Works:
Most common for single family homes and small multifamily, this method determines the value based on comparisons to similar recently sold nearby properties ("Comps"). The appraisal value is adjusted up or down depending on how the different features of the property stack up against the comps. Number of bedrooms, overall square footage, number of garage spaces, overall condition of property, cosmetic upgrades, etc. are all considered in the comparison. This approach is easy to understand and can be a way of quickly estimating what a property may be worth.
Although this process is fairly straight forward, values can vary depending on the appraiser and the comps chosen. If given the opportunity, be sure to share with the appraiser any major upgrades you've done to the property since it was purchased, and if appropriate share the dollar amount invested. After receiving the appraisal, you can very carefully discuss the report, ask questions, and offer suggestions. For example, you want to say something like "I agree with your analysis and methodology, however, I'm curious why the comp down the street wasn't used. It seems very similar to this property, and I believe including it in the analysis will increase the appraised value. Would it be possible to include this comp in the report?" By taking a careful approach rather than a confrontational one, the appraiser is more likely to consider your suggestions. Be sure that you are operating in a legal manner, as some jurisdictions prohibit certain interactions with the appraiser.
Replacement Cost Analysis Approach
This approach essentially determines the cost to completely re-build the property plus the value of the land and any income-producing factors. While not a typical approach utilized by appraisers when buying and selling property, this method can be very useful for various scenarios:
For insurance purposes, can be utilized to determine the cost to completely rebuild the property in the event it was destroyed by a fire, weather event, etc.
The property is located in an area with little to no comparisons available.
Newly built properties or large developments with no established history.
Income Analysis Approach
This is the most common approach for commercial appraisals and uses income data from the property to estimate property value. The formula is pretty basic: Net Operating Income (NOI) divided by the market Capitalization Rate (Cap Rate):
The NOI is determined by subtracting operating expenses from total revenue. Operating expenses include insurance, property management, utilities, property taxes, repairs, etc. However, capital expenditures, loan interest, income taxes, etc. are NOT considered operating expenses. Total revenue includes rental income, parking fees, laundry machines, service charges, vending machines, and anything else that brings money in periodically.
The Cap Rate is a method used to evaluate the average return on investment for a specific property class in any given market. Any investor can use this to quickly determine the potential return of a property they're considering. It is a percentage determined by dividing the property's NOI by current comparable market value. The market cap rate for a particular property class is determined by performing this calculation on a number of comparable properties.
Here is a basic example:
Value = $450,000 (Yearly NOI) / 7.5% (Market Cap Rate) = $6,000,000.
Often an investor will want to know what the potential future value of a property is after adding value, increasing rents, and therefore increasing Yearly NOI. This would be determined using the following example:
Est. Future Value = $650,000 (Expected Yearly NOI) / 7.0% (Market Cap Rate) = $9,285,714.
Note that in the example above, the market cap rate changed from 7.5% to 7.0%. This is because after adding value, the comparable sales change, therefore changing the data in the market cap rate analysis. In the example, higher-end properties have a lower cap rate than the current market class. The investor can now use the estimated future value of $9.285 million to determine whether the $6.0 million purchase price + expected capital expenditures will lead to an attractive return. They can also use this to determine which strategy to pursue for this particular property (buy and hold, add value and refinance, add value and sell, etc.).
Hopefully this article gave you a better basic understanding of the most common appraisal techniques used in real estate. Understanding these methods is critical to every transaction.
As always, feel free to reach out with any questions.