Whether you’re buying or selling a house, insuring it, paying taxes, or planning your finances, property appraisal plays an important role. Appraisal, or property valuation, determines what a property is worth.
But how do realtors, insurers, mortgage lenders and other financial institutions work out what a property is worth?
Read this guide to find out all about the intricacies of appraisal methods and the diverse approaches professionals use to determine the value of a property.
Understanding Property Value
Market value is the cornerstone of property appraisal. It’s the most probable price a property should sell for on the open market under all conditions needed for a fair sale. Factors such as location, condition, features, and current market trends significantly influence market value.
Property valuation also involves a subjective element, incorporating buyers’ perceptions and preferences. However, for fair and consistent pricing, appraisers must rely on objective criteria. This has resulted in the development of tried and tested systematic appraisal methods.
Accurate appraisals also consider the following principles:
- Conformity: A property gains maximum value when surrounded by buildings with similar architecture and land use.
- Change: Property values fluctuate according to the current economic conditions.
- Substitution: A property’s maximum value can be limited by the costs of a substitute or similar building.
- Supply and demand. High demand and limited supply leads to price increases.
- Highest and best use: Appraisal assumes that owners or tenants will use the property to its highest and best purposes.
- Progression: A property’s value will climb if more valuable properties spring up in the area.
- Regression: The property’s value will drop if less valuable properties are constructed nearby.
- Anticipation: This considers the property’s potential future benefits.
An appraisal approach is the process of determining the value of properties based on considerations such as their fair market value and cost. The income they’re likely to generate in comparison to similar properties is also considered.
Once professionals have assessed the property, they reach a probable selling price. Realtors then market the property to prospective buyers who fall into this price bracket.
While appraisals are typically required when properties go on sale, they’re often also necessary for insurance and taxation purposes.
How Appraisers Determine A Property’s Value
Now you know some of the theory behind appraisal approaches, let’s explore the different methods appraisers use to arrive at their final estimates.
There are three primary methods to assess a property’s value and a few others to cross-check the final figure.
1. The Sales Comparison Approach
This method, also known as the Market Approach, is the one most professionals use to estimate the value of residential properties. Appraisers compare the property to similar recently sold listings. They consider the size, features, and location and adjust the value up or down according to the differences between the properties.
To ensure an accurate figure for the property’s current value, appraisers use data from at least three recent property sales. This allows them to account for age, features, and condition discrepancies.
2. The Income Approach
This valuation approach is based on the theory that a property’s worth should be determined according to the income it generates and will generate in the future. Appraisers typically use this method for valuing commercial buildings, multifamily properties, and rental apartments.
To determine a property’s value using this method, the appraiser calculates the potential rental income. They take into account occupancy rates, market rental rates, and any other rental incomes associated with the property, such as laundry or parking amenities.
From this figure, appraisers subtract all expenses, like maintenance costs, taxes, insurance, and management fees, resulting in the net operating income (NOI). The next step is applying a cap rate in proportion to the property’s risk and the ideal rate of return. You will find the property’s value by dividing the NOI by the cap rate.
3. The Cost Approach
When appraisers use this method to value a property, they base their calculations on what it would cost to construct a similar building from the ground up again, taking into account obsolescence and depreciation.
Once they have this figure, they consider depreciation arising from wear and tear, outdated features, and external factors that cause the property to depreciate. Deducting the depreciation costs from the replacement costs gives you the property’s final cost-approach value.
Secondary Valuation Methods
Appraisers may consider using other methods depending on the type of property concerned. These include:
Price Per Square Foot
Here, the value depends on the total space available. Property values differ substantially from city to city or even within the same neighborhood.
To work out this price, you’ll divide the property’s price by the overall square footage to gain an estimate of the property’s value.
Although this doesn’t provide all the necessary information, it’s an excellent secondary method to cross-check other evaluation methods.
Gross Rent Multiplier (GRM)
Professionals use this method to value properties that generate income, making use of a factor known as the Gross Rent Multiplier. They calculate this factor by considering comparable sales and market conditions.
Appraisers multiply the gross annual rental by the area’s average GRM to get the property’s value.
Who May Determine Property Value?
To deliver a legitimate appraisal, a professional must have expert real estate knowledge, pass the necessary training courses, and achieve the requirements of the Universal Standards of Professional Appraisal Practice (USPAP).
Challenges In Property Valuation
While the appraisal methods professionals use are fairly standard, it’s not an exact science, and they may face certain challenges:
- Market fluctuations, economic conditions, and supply and demand trends can influence property values.
- Some properties may have unique features that can complicate the valuation process. Historic homes, custom-designed properties, or those with unconventional structures may require specialized expertise.
- Appraisers must adhere to legal and regulatory guidelines.
- Data availability and integrity are essential for calculating the true value of a property.
- Choosing the appropriate appraisal technique is crucial for a relevant and accurate valuation.
Proper property valuation is essential, not just for realtors who buy real estate leads to target a specific price bracket, demographic, or neighborhood, but for buyers, sellers, and investors too. Having access to accurate market values allows everyone to make informed, data-driven decisions.
To ensure an accurate, unbiased result, appraisers use various methods, with each approach offering unique insights into a property’s worth. These approaches allow them to provide a well-rounded, accurate estimate of a property’s value. As the real estate sector continues to evolve, the importance of skilled appraisers remains crucial as these professionals facilitate fair and informed transactions for everyone involved.