Our Appraisal Methods
The appraised value of the real estate would be of particular interest to a home buyer as we don’t want to pay way above what a property is worth, and a home seller does not wish to be shortchanged by selling at a price way below value.
However, in reality, the appraisal conducted by a qualified appraiser would determine an assessed value of a property that a lender uses to evaluate how much percentage (in terms of loan-to-value) to loan to a borrower to finance the property. This can either be in the form of property purchase, refinancing, home equity loans, etc. If anything, the appraiser works for the lender indirectly or directly in some cases, as their job is to help the lender underwrite mortgages more prudently.
Insurers also have a stake in this as they need property value to underwrite homeowners’ coverage. But their risks are much less than what a lender is exposed to. The importance of providing a reasonable estimation of real estate value in appraisal reports cannot be undermined. For example, a rough valuer can grossly overvalue a property, resulting in a lender approving a loan over what the property is worth. This leads to real estate and mortgage fraud. This is why appraisers are sometimes under scrutiny in terms of how they conduct their valuation activities.
There are three main types of home appraisal methods used by appraisers in the real estate industry.
- Cost Approach
- Income Approach
- Sales Comparision Approach
The cost approach to valuation is a simple method of determining how much it would cost a homeowner to completely replace the existing house with a similar one on the same piece of land. This is related to the replacement costs. Because depreciation has to be accounted for in this concept, the cost approach tends to be more reliable when the property is new. This is because the older a property gets, the more improvements would have depreciated. And the more difficult it would be to accurately calculate the amount of depreciation to place on the house.
In addition, land value cannot be estimated since it cannot be replaced. The costs of replacement can also vary as time passes. The prices of finished and raw materials for building and construction can be affordable today but much more expensive in a year. This can significantly affect the cost of replacing the current property with an exact replica in the future.
Cost appraisals are most appropriate when a property is somewhat unique, and there is no comparable real estate to compare it against.
When the ability of a property to produce income is the primary data source for estimating its market value, then its appraisal uses an income approach, sometimes referred to as the capitalization approach. This is a very appropriate method of evaluating property value when the subject in question is a property generating rental income. Thus, it is one of the more popular valuation techniques used to assess commercial and other rental properties.
The math and equation behind this are by summing up the total rental collections, deducting expenses, and using multiple earnings to place a value on the property. As you can probably tell, this is the language of investors who make business decisions based on numbers, and that is also its drawback. This method is generally considered more technical and does not account for qualitative factors that cannot be quantified.
The sales comparison approach to property valuation is the method that resonates the most with regular homeowners. After all, when was the last time you ran into a home seller who did not reference the high transaction price of a neighbor recently? This method of assessment has more weight on market data and precisely how many similar properties in the area recently went for in the market.
The comparable properties are often called comps in short. The sales comparison approach is often used on residential property. Especially those that have a lot of comps like townhouses, manufactured housing, condominium units, etc.
The challenge with this method is that it might not work well with standalone houses since it is almost impossible to find two identical houses. And even if they look similar on the outside and the floor plan, the interiors can be vastly different.
What does all this mean?
It must be said that any appraiser worth their salt should have an open mind about how their property valuation is determined. On top of that, they also tend to practice reconciliation to sieve out errors or mistakes.
It can sound unprofessional to say this. But appraisers seldom come up with the same estimates on the same property even though they are meant to be qualified to practice this scope of work. It’s just how the different types of real estate appraisal methods work. This is because how they value a property can also depend on experience, personal preferences, biases on certain factors, etc. This means that even though they are depended on to provide a qualified opinion on property value, remember that it’s just an opinion or estimate. This is also why lenders often obtain indicative values from at least two appraisers to reduce the risks that come with appraisal errors and average them out.
It is also not surprising to have appraisal companies get more than one appraiser to estimate value, reconcile differences, and submit to a lender. The lender then gets at least two appraisal companies who do this internally. Then the lender proceeds to conduct their own reconciliation of the two appraisal reports. All these are for the reason of reducing the margin or error to reduce the exposure to risks.