Although there are a number of reasons for a residential real estate appraisal, the primary reason most individuals get an appraisal is for mortgage lending. Either the homeowner is buying or selling a home, or they are re-financing the property to pull money out or get a lower interest rate.
In most instances, the appraisal is for the lender, who wants to know if the property has sufficient value to serve as security (collateral) for the loan the lender is being asked to make. If the owner wants to refinance, the the lender will use the appraisal to insure that the market value of the property is sufficient to underwrite the loan.
Cost of Credit
Most buyers of residential real estate can not afford to pay cash for home. They typically finance the home purchase with a loan. Interest paid on that loan is the "cost of credit" to the borrower. Sometimes the cost of credit is high, which means that some borrowers are unable to qualify for a loan compared to other times when the price of financing is not as expensive. Credit is "tight" when there is not enough financing to accomodate those who want to a loan.
A mortgage on a residential property creates a "lien" on the home. The lien allows the lender to take back the property if the borrower fails to meet the obligations of the loan agreement. Enforcement of the lien against a borrower who does not pay their mortgage is called a foreclosure. Payment of mortgage debt almost always requires payment of both the amount loan, (the principal), and interest, (the charge for borrowing the money).
For more information on residential appraisals, and the codes that appraiser's use when valuing your home, click here.
The definition of market value assumes an arm's length transaction, with typical conditions that include:
Although most appraisals use market value, there are other values that influence real estate value. That said, at their core, they are values in exchange that have market value as their bedrock principal. Other values include:
There are many factors that influence market value, but the primary consideration for the appraiser is Highest and Best Use. In summary, the Highest and Best Use is the use that will provide the highest income. This determination involves and analysis of the neighbrhood, its community, the subject site, and the subject improvements. The four factors that are always considered in Highest and Best Use are:
The Sales Comparision approach is the approach best understood by the general public. Sales are found that are similar to the subject. The appraiser evaluates any similar or dissimilar characteristics and makes adjustments for each. These may by physical differences, locational differences, differences in buyer-seller motivation and financing, time or date os sale differences, and others.
The Cost Approach estimates the value of the land, site improvements, and vertical improvements. For the vertical improvements, either reproduction or replacement costs are estimated. From these estimates of new building value, depreciation of the improvements are then estimated and subtracted. Depreciation types include physical, functional and/or external obsolescence. With depreciation determined, value is estimated by adding site value, site improvements, vertical improvements, and then subtracting depreciation.
The Income Approach is based on net income, or return on investment, that can be reasonable expected from the property. The sales price is determined by what a buyer would pay given the probable return, or yield, from the real estate. This is often based on net operating income (NOI). NOI is not just rents. Net operating income takes rent, then subtracts out expenses, including vacancy and credit loss, variable expenses like utilities, maintenance and repairs, and management, then fixed expenses like taxes, and insurance. One all expenses have been accounted for, they are subtracted from rents, leaving a net operating income. Once a net operating income is determined, an appropriate capitalizaiton rate is divided into the income to estimate property value. If net income is determined to be $22,500, and a return rate of 9% is reasonable, then the $22,500 is divided by .09 to estimate value as $250,000.
With residential property, a more common approach to value estimate is by using a Gross Rent Multiplier (GRM). To use a GRM, sales of residential income property are found. With each sales, both the gross rent and the sales price must be known. Gross rent is then divided into sales price to determine a Gross Income Multiplier (GIM). With several similar GIM's, an appropriate multiplier for the subject is determined. When the appraiser has determined an appropriate multiplier, the multiplier become known as a GRM when used as a multiplier against the subject's gross rents. The appraiser then multiplies the GRM by the subject's gross rents to determine a value estimate.