Owning a home is part of the American dream, and it is often good for the buyer, and good for local, state, and national government. Home ownership can give people a reason to be more involved in the community, and to assist in shaping their identity. Home buying is the single largest financial investment most people make, and most buyer’s want to protect their investment. This desire to protect their investment with proper maintenance and care is good for the neighborhood and draws the homeowner into community engagement, compared to renters, who are often short term residents with comparatively little desire for neighborhood improvement.
The purchase of a new home supports the construction industry, and adds to the tax base of local government, either thru direct property tax, or by increased sales tax as local residents buy goods and services from nearby business. These nearby businesses are usually required to pay a sales tax on transactions, which increases revenue to local government. In this way, a robust market for real estate contributes significantly to the local, state, and national interests.
Real Estate Appraiser
Home or residential real estate appraisers are hired to provide an opinion of value about residential property. Appraisers do not create or establish value – only buyers establish actual market value as evidenced by their purchases. Appraisers simply try to understand how buyers would look at a subject property, and estimate a value based on evidence from these buyers.
Automated Valuation Model
Automated Valuation Models (AVM’s) are computerized algorithms written to process property data to concluded various statistical data, including property value. These AVM’s offer quality control and analysis, audits, refinance value and other information. These technologies compete with traditional appraisals, resulting in fewer appraisal assignments. However these technologies are criticized for offering lenders an opportunity to select the highest value estimate from the various AVM’s. With high value estimates, lender’s can offer larger mortgages with the justification that the property has the collateral needed to pay back the loan if they have to foreclose. This is the same mentality that contributed to the S&L melt down of the 1980’s, and the subprime mortgage crisis of 2007-2008, which drove the Great Recession that followed.
Appraisers use three traditional valuation approaches to determine value, (cost, sales and income). To determine value, the appraiser must select comparables with similar economic characteristics. The comparable should appeal to the same buyer’s that would consider the purchase of the subject property. It should be in the same market area and ideally has sold recently.
Cost Approach Appraisal
The cost approach is based on the reasoning that a buyer would not pay more for a property than it would cost to purchase land and build improvements of similar quality and condition. For an appraiser to develop a cost approach, they need to consider:
- Land value of a site.
- Direct and indirect costs of the improvements. Direct costs are money to be spent for materials and labor. Indirect costs include management costs, architectural and engineering fees, permits, financing costs, insurance, sales and lease-up costs, etc.
- Entrepreneurial Incentive. This means that nobody works for free. If you are a developer, and you are going to put the work into a new build, you are going to want to be paid for your effort.
- Depreciation. There are three major categories of depreciation which are physical, functional and external. Physical depreciation focuses on the age of the building. A new build is probably in better physical condition than a property that is 50 years old. Functional depreciation deals with improvements that are outdated compared to modern builds. Perhaps the A/C system is inadequate, or the property has a pool that is no longer adding value to the property. External depreciation are factors outside of the property boundary, (the property is near a landfill and nobody will buy it).
- Reconcile the above into a single value estimate for the cost approach.
Sales Comparison Approach
The sales approach is the most reliable and direct value approach for most real property, (if there have been sales). The sales approach is simple, uses market data, is applicable in most situations, and is widely understood by the general public.
- Use sales, listings and pending offers from properties that are similar to the subject.
- Find relevant units of comparison for analysis, ($/SF, $/unit, $/acre, $/bedroom, etc)
- Compare the comparables to the subject in terms of the various elements identified above, and adjust the sales price of the comparables to reflect how they differ from the subject.
- Reconcile the above into a single value estimate.
The income approach to the valuation of residential property is applicable when there is an active rental market, and when the typical buyer would consider rental income in their decision to purchase. It is based on the assumption that property value is related to the properties ability to produce income. The most common technique for valuing a single residential property from the income approach is to use a multiplier on the income, (usually a Gross Rent Multiplier or GRM).
- Determine the GRM from recent sales of similar rental property. Divide the sales price by the monthly, (or yearly) rental income, which determines the GRM.
- Estimate the monthly or yearly income of the subject property by doing an investigation of typical rents for similar properties.
- Multiply the GRM by the monthly, (or yearly) rent to obtain an indication of market value.
- Reconcile the above into a single value estimate.
Final Reconciliation Appraisal
With the three approaches outlined above, (cost, sales and income), the next step is final reconciliation. If more than one approach was used to value the subject, then the values must be reconciled to arrive at a final opinion of value. In essence, you choose which approach gives the best answer for value, given the current subject market.
If you would like to learn more about the specifics of the appraisal process, feel free to contact Jim to learn more. Contact info.