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3 Main Types Of Home Appraisal Methods
The appraised value of 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 as he does not want to be shortchange by selling at a price way below value.
But in reality, the appraisal conducted by a qualified appraiser would determine an assessed value of a property that is used by a lender 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 in a more prudent manner.
Insurers also have a stake in this as they need property value to underwrite the amount of coverage for homeowners. But their risks is much less than what a lender is exposed to.
The importance of providing a credible 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 that is way 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 3 main types of home appraisal methods used by appraisers in the real estate industry.
- Cost approach
- Income approach
- Sales comparison approach
Each of them have their pros and cons, advantages and disadvantages.
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 tend 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 to this, the value of land cannot be estimated since it cannot be replaced.
The costs of replacement can also vary as time passes.
The prices of finished and raw material for building and construction can be affordable today but much more expensive in a year’s time. This can greatly 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 no real comparable real estate to compare it against.
When the ability of a property to produce income is the main data source for estimating it’s market value, then it appraisal is using an income approach, or sometimes referred to as capitalization approach.
This is a very relevant method of evaluating property value when the subject in question is an income property that is generating rental income.
Thus, it is one of the more popular valuation techniques used to assess commercial property and other rental properties.
The math and equation behind this is by summing up the total rental collections, deducting expenses, and using a multiple of earnings to place a value on the property.
As you could probably tell, this is the language of investors who make business decisions based on numbers.
And that is also it’s drawback.
This method is generally considered as more technical and does not account for qualitative factors that cannot be quantified.
Sales comparison approach
The sales comparison approach to property valuation is the method that resonates the most with regular home owners.
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 takes puts more weight on market data.
Specifically how much similar properties in the area went for in the market in recent times.
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 town houses, manufactured housing, condominium units, etc.
The problem 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 on the floor plan, the interiors can be vastly different.
What all these means
It must be said that any appraiser worth their salt should have an open mind with how their valuation of properties are 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 same estimates on the same property… even though they are meant to be qualified to practice this scope of work.
It’s just the way the different types of real estate appraisal methods work.
This is because how they value a property can also depend on experience, personal preferences, biasness 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 in order to reduce the risks that come with appraisal errors, lenders often obtain indicative values from at least two appraisers and average them out.
And sometimes, they get more than two.
It’s also not surprising to have appraisal companies to get more than one appraiser to estimate value, reconciliation differences, and submit to a lender.
The lender then gets at least two appraisal companies who does this internally. Then the lender proceeds to conduct their own reconciliation of the two appraisal reports.
All these for the reason of reducing the margin or error so as to reduce the exposure to risks.