What is a property worth?
The question of how much money you can make from a real estate investment is key to predicting your investment’s profitability. However, the answer to this question is not always straightforward.
This text is discussing ways that real estate investors can assess the value of a property before making an offer. It lists the three most common methods used by appraisers to value a property, and explains how each one works. By knowing how much a property is worth, how much it will cost to renovate, and how much it will be worth after repairs, investors can more accurately estimate their profits from a deal.
Property valuation overview
Purchasing property is unlike acquiring many other goods and services where there is typically a fixed price. Property values are not stagnant, in fact, they often fluctuate based on the market and what potential buyers are willing to pay. However, value and price aren’t always equivalent in the realm of real estate.
Value vs. price vs. cost
Property owners list their properties for sale at an asking price, but buyers are often willing to pay a lower price.
In this scenario, the home that sold for $100,000 is undervalued, while the home that sold for $200,000 is overvalued. The final cost of a house may not show how much it is really worth. For example, two houses that are exactly the same could be next to each other but one sell for $200,000 because that is what similar homes in the area are going for. The other house might only sell for $100,000 because the owner was selling it to their daughter and the price did not reflect what the house was actually worth on the market. In this case, the house that sold for $100,000 would be considered undervalued while the other one that sold for $200,000 would be overvalued.
Value and price are often different from a property’s replacement cost. For example, a 200-year-old home that is beautiful might have a market value of $500,000 based on what current buyers are willing to pay. However, if it burned down, it might cost $600,000 to build an identical replacement based on today’s material and labor costs.
In short,
- Price is what a buyer actually pays
- Cost is what it would cost to build a replacement home today
- Fair market value is what a stranger would theoretically be willing to pay for a home based on today’s demand for similar housing
Different types of value
Not all real estate valuation is created equal. However, different types of buyers and sales methods can produce other types of values:
- Liquidation value aims to estimate what price a property would bring at auction, if forcibly sold (e.g. through foreclosure or bankruptcy). Liquidation value is nearly always lower than fair market value.
- Value-in-use is the value of a specific use of a property to a specific owner. For example, if a property is currently used as short-term vacation rental property by a small business, its value-in-use is based on their revenue and may be different from the fair market value that a homebuyer would be willing to pay.
Who evaluates properties and how much do valuations cost?
In addition to the transacting parties, there are several industry professionals who conduct inspections and offer input to the seller, buyer, and lender.
- Realtor: When first hiring a realtor, the seller typically asks the realtor’s opinion on value and listing price. This opinion could be verbal and informal (often called a comparative market analysis or CMA), or it could be delivered in an official report as a broker price opinion (BPO). While not as thorough as an appraisal, BPOs may be completed faster and cost less, usually between $125 and $225 when ordered separately and may be completed by a professional who could be a real estate agent, a real estate broker, an appraiser, or other qualified person.
Broker price opinions are an estimate of value on a property, ordered by lenders who need a quick estimate, typically for properties headed for foreclosure or loan modification. Realtors typically don’t charge for a CMA or BPO if it’s completed as part of a listing agreement.
- Home Inspector: Upon signing a contract with a seller, the buyer typically orders a home inspection and an appraisal. Home inspections are extremely thorough and often takes several hours to complete. The home inspector evaluates the building’s structure, foundation, roof, mechanical systems, wiring, and functional age. Home inspections range in cost from $300-450, depending on the size of the home. Buyers use this information to confirm that the property is in the condition they expected when they made their offer. Obviously, a home’s condition affects its value, and if the home inspection reveals a major structural problem in the foundation, then the property’s value will reflect the needed repairs. Read up on additional ways to make the most of a home inspection here.
- Appraiser: Ideally, the home inspection should be performed before the house appraisal, so the appraiser can review the home inspection report and take it into account when forming the property valuation. The typical cost for a house appraisal ranges between $300-400. While the home inspector’s job is to assess the condition of the property and any needed repairs, the appraiser’s job is to estimate its value using one of three valuation methods below.
What is the fundamental issue?
NAR members have had concerns about appraisals for real estate transactions for the past year. These concerns are mostly about discrimination in the appraisal process, the use of automated or alternative valuation methods, a shortage of appraisers, and attracting new and diverse appraisers to the business.
I am a real estate professional. What does it mean for my business?
There has been an increase in media stories in the past few years alleging discrimination in the appraisal process. A few studies have suggested that there might be bias in the appraisal process, particularly with regard to the choice of comparable sales based on the race of the homeowner/seller. In Fall 2021, Freddie Mac released a study based on their own appraisal data suggesting that a property is more likely to receive an appraisal lower than the contract price if it is in a minority tract. More research into actual appraisal reports and assessment of fair housing complaints is expected.NAR supports states that are developing policies to address concerns about discrimination in the valuation process. NAR is committed to ensuring that the real estate market is safe and secure, and urging entities that are trying to change the valuation process to include appraisers in the review and development process of any new standards.
Many people in the housing industry, including the National Association of Realtors (NAR), support the role of appraisals and their contribution to the safety and soundness of the mortgage lending industry. However, there is an increased reliance on automated valuation methods (AVMs) for valuation purposes, as evidenced by the decisions of both Fannie Mae and Freddie Mac to allow data driven valuations, rather than traditional in-person appraisals, for certain, lower risk purchase transactions. NAR is supportive of technological advancements that support the housing market, but has some concerns with the use of automated valuations in purchase transactions.
Appraisers are leaving the profession at the same time that entry of new appraisers is dwindling. This is causing a shortage of appraisers. Entrepreneurial opportunities for appraisers are disappearing and many are concerned with over-regulation in the field. There are also barriers to entry, such as education requirements, that could be affecting incoming appraiser numbers.
It is more difficult to attract new people to the appraisal profession. The Appraisal Qualifications Board revised the Real Property Valuation Criteria to allow for more flexibility in fulfilling the college-level education requirements for appraisers and reducing the number of experience hours in early 2018. The AQB is now exploring alternative methods to provide appraisers in training with the required education, including exploring virtual property inspections and partnerships with other educational institutions.
3 Real estate valuation methods
An appraiser will use one or more of the following methods to determine the value of a property: the sales comparison approach, cost approach, and income capitalization approach.
Real estate appraisal method 1: The sales comparison approach
The most common way for appraisers to estimate the value of a property is by analyzing comparable properties that are in the same area.
It makes sense that if you want to know how much one property is worth, and an identical property just sold next door, that would be a clear indication of value as long as the transaction was between two strangers and not between family members.
The appraiser must find similar properties that have sold recently to determine the value of the property being appraised.
Here are a few factors that appraisers must account for when reviewing comps:
- Home size
- Lot size
- Home age and condition
- Home amenities
- Location desirability
- Proximity to home in question (the closer, the better)
- Date of sale (the more recent, the more accurate)
Property valuation is not an exact science because there are variations in comps. For example, it is more accurate to compare a property across the street that has more bedrooms and sold nine months ago, to a property with a similar layout ten streets away that sold last week.
The reason why three different appraisers would come up with three different values for the same property is because they are only an estimate of value, not a guarantee of a specific price. It is important to learn about how to use comps to determine home values, so that you can analyze property values without having to constantly ask realtors or appraisers for help.
Example:
Andy Appraiser wants to find out how much a home is worth right now. The home has three bedrooms, two full bathrooms, and 1,500 square feet.
He looks at nearby homes that have sold recently and finds three similar comps that sold within the last four months:
This home has three bedrooms, two bathrooms, and is 1,350 square feet. The sales price is $195,000.
This home has four bedrooms, two bathrooms, and is 1,650 square feet. It is being sold for $235,000.
The home has three bedrooms, two bathrooms, and is 1,450 square feet. It is being sold for $205,000.
Andy estimates the property value at approximately $205,000 – $210,000, after confirming that the condition of the three other properties was the same as the one he was investigating.
Real estate appraisal method 2: The cost approach
An appraiser may have difficulty finding comps when appraising a house. This can be the case when the house is rural and has no nearby homes, or when the house is unique, like a castle or a converted church.
The cost approach to real estate appraisal estimates the value of a property by quantifying the cost of reproducing it.
The appraiser must take the current condition of the property into account. An identical brand new house would be worth less than a perfect new house, so the appraiser uses a technique called depreciation to estimate how much the current house is worth.
Some of the factors appraisers consider for depreciation include:
- The home’s physical deterioration: examples include old mechanical systems, old appliances and fixtures, and the condition of the roof, foundation, and other structural components.
- Functional obsolescence: an outdated way of building or structuring homes. For example, an upstairs layout where the only way to reach one bedroom is to walk through another.
- Economic obsolescence: neighborhood or other location-based factors that leave the property less valuable. An example is if a six-lane freeway was recently built right next to the property.
The appraiser estimates the value of the land by looking at comparable sales, then estimates the cost of construction to replace the building. Finally, they estimate the amount of depreciation and subtract that from the value to reach a property valuation by cost method.
Example
Andy Appraiser has been hired to draft a house appraisal on a castle sitting on 100 acres. After reviewing sales of nearby undeveloped land, he estimates the value of the castle at $5,000,000.
Andy then estimates that it would cost $200 per square foot to build a new castle using the same materials. The castle has 10,000 square feet, putting the replacement cost at $2 million.
Andy had received a home inspection report which estimated that it would cost $300,000 to renovate the castle back to a like-new condition.
Thus, Andy calculates the castle’s value like this:
Land: $500,000 +
Building replacement cost: $2,000,000 –
Depreciation: $300,000 =
Value by cost: $2,200,000
Real estate appraisal method 3: The income capitalization approach
The value of certain properties is based on their potential to earn income.
Properties that generate income can be valued using one of two methods: direct capitalization or gross income multiplier. direct capitalization involves estimating the property’s value based on its potential income. The gross income multiplier method also uses income potential to calculate value, but it is based on the sale price of comparable properties.
The appraiser determines the value of the property by capitalizing the net operating income at a chosen rate. The appraiser first calculates the net operating income for the property by adding up all annual rents and subtracting all expenses. The appraiser then determines the value of the property by capitalizing the net operating income at a chosen rate.
They then look at the capitalization rates of similar properties and multiply the NOI by the cap rate multiplier to estimate the value.
Gross income multiplier is a method that appraisers use to estimate the value of a rental property. They look at the relationship between local rents and local home prices to find a multiplier. They then multiply the property’s rent by this multiplier to get an estimated value.
Examples
Andy the Appraiser needs to appraise a four-unit rental property. He tries both the direct capitalization method and the indirect capitalization method.
Using the direct capitalization approach, he uses the following math:
Gross annual income: $48,000 ($4,000/month) –
Annual expenses: $20,000 =
NOI: $28,000
Local cap rate: 8%
Estimated value: $28,000 x (100/cap rate) = $350,000
Then he uses the gross income multiplier method. So, this calculation goes as follows:
$4,000 monthly rent x 85 = $340,000
The method used to calculate the amount of money that Andy will receive is similar, but not exactly the same, as the direct capitalization approach. The amount of money that Andy will receive is up to Andy’s best judgment.
