How Do Appraisers Determine Real Estate Value

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Answered by: John, An Expert in the Business Real Estate - General Category
Any person buying a personal residence, investing in real estate, or refinancing a property should expect to pay a minimum of $300 to $400 for an appraisal. An appraisal helps facilitate the transfer of ownership or to finance property by establishing real estate value. Many investors and sellers use an appraisal to decide how much to offer, list price, basis for a property exchange, or merge ownership of two or more properties.



Real estate brokers routinely use two types of informal property valuation methods: Comparative Market Analysis (CMA) or Broker Price Opinion (BPO) to provide their client an informal estimation of a property's value.

About CMAs and BPOs



Most individual investors and sellers use a CMA to determine real estate value. The CMA assesses a property's value as weighed against sales data for similar real estate in a neighborhood. The CMA provides the pricing data necessary for a user to make an informed decision prior to presenting an offer to purchase real estate or list a property for sale.

A BPO provides a user more extensive information compared to the contents of a CMA. This report includes data on a neighborhood property values, sale price trends, cost of repairs, and expenses for getting a property ready to place on the market, according to the National Association of Broker Price Opinion Professionals. Banks, attorneys, estate executors, and other parties use BPOs to estimate a property's value prior to listing it for sale.

Understanding the Appraisal Process

Real estate brokers employ an informal and subjective process to formulate a CMA or BPO reports. The accuracy of data depends on the agent's experience and other factors that affect real estate market value. In contrast, appraisers must undergo extensive formal training and obtain a license or certification to work in the state where they practice.

Many appraisers have memberships in the Appraisal Institute. These professionals promise to follow certain guidelines as outlined in the Code of Professional Ethics and Standards of Professional Appraisal Practice of the Appraisal Institute. Members must also complete continuing education classes, which keep them up-to-date on industry changes and best practices.

Appraisals provide lenders, investors, sellers, brokers, and other clients a concise, regulated, and professional approach to reaching an estimate of a property's value.

The appraisal process entails six primary steps:

1.     Definition of the problem

2.     Primary survey appraisal plan

3.     Data collection and analysis

4.     Application of three valuation methods -- replacement cost, sales comparison, and income capitalization

5.     Reconciliation of value indications

6.     Final estimate of property value

For real estate investors, the most crucial phases of the appraisal process involve the last three steps -- the three approaches use to value real estate, how the appraiser reconciles methods to determine value, and the methodology used make the final determination of value.

Here are the three methods appraisers use to estimate value:

Cost Approach

The basic concept underlying the cost approach focuses on how the market associates a property's value to cost. In short, an informed investor will not pay more for a property than the cost of reproducing or replacing the same structure, plus the value of the land. Appraisers use the cost approach for new properties, nearly new structures, and properties unique to the market.

The evaluation starts with the appraiser determining a site's value by reviewing sales data on similar vacant land. Next, the appraiser relies on information collected from contractors, developers, cost manuals, and cost estimators, to calculate the replacement cost. The appraisal must include various degrees of depreciation, such as physical wear and tear, functional obsolescence, and external obsolescence.

Functional obsolescence refers to a variety of factors about the property that influence its value, such as size, outdated building systems, or high operating expenses. External obsolescence denotes factors outside the property that affects value, such as a depressed real estate market or environmental concerns.

Sales Comparison Approach

Appraisers use the sales comparison method when the local market has multiple sold or listed properties, especially single-family homes, townhouses, and condominiums. The appraiser calculates the subject property's value by comparing the property to similar real estate. The subject property usually appraises at somewhere between these values.

The sales comparison method requires an appraiser to look at a variety of elements when evaluating the degree of differences/similarities between the subject property and comparable sales.

Common factors considered by the appraiser include the following items:

"     Location

"     Market conditions

"     Economic characteristics

"     Physical characteristics

"     Financing terms

"     Conditions of sale

The appraiser must also consider zoning regulations and any property rights convey with the subject and comparable sales properties. Ultimately, the appraiser adjusts the sale price of each comparable property to arrive at a value range for the subject property and makes a final determination of price.

Income Capitalization Approach

Real estate investors want to know an income-producing property's future earning potential to determine the present value of the property before consummating a purchase. Income capitalization provides a method for measuring the present value of a property based on anticipated market rents, vacancies, reversion, resale of the property, and other factors.

The income capitalization method converts expected cash flows into present values by "capitalizing" the property's net operating income based on the market's capitalization rate. Investors should think of a capitalization rate as a return on investment in the same manner as a dividend paid on stock. Most income-property investors use the capitalization rate as a marker for determining how much to pay for real estate.

Appraisers use capitalization rates from comparable sales. Then, they apply the capitalization rates to the net income of the subject property to calculate the estimated value. Three variables affect capitalization rates: 1) variations based on the local market, 2) property type, and 3) economic conditions.

An appraiser employs one of two methods to determine a property's earning potential: direct capitalization or yield capitalization.

The appraiser selects the approach based on several factors, including timing, the duration of leases, consistency of cash flows, and the length of time the owner holds the investment. Most appraisers prefer the direct capitalization method over the other options because it is faster and less complicated.

For example, a 24-unit investment property with a steady annual operating income and short-term leases, which enable the cash flow to keep pace with market rents, makes a good candidate for the direct capitalization approach.

Conversely, calculating the yield capitalization requires the appraiser to make projections concerning income, holding duration, and resale value. The process does not incorporate comparable sales. Yield capitalization requires the appraiser to estimate an applicable interest rate. The appraiser determines the property's present value by applying the yield rate to different cash flows scenarios (future benefits) and must include irregular cash flows.

Reconciliation and Determining Final Value

During the reconciliation phase of the process, the appraiser conducts a comprehensive review of all data, techniques, and the appraiser's reasoning. After analyzing various assumptions, which includes at least two approaches for determining the subject property's value, the appraiser makes a final real estate value determination.

The process hinges on an appraiser's experience, competency, reasoning skills, and professional judgment to reconcile discrepancies in value and reach a single estimation of real estate value.

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