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Real estate appraisal methods.
Appraisers typically use three appraisal methods:
1. Sales comparison approach
2. Cost approach
3. Income approach
Respective method addresses a particular type of property.
SALES COMPARISON APPROACH
In this method an estimate of property value is obtained by comparing the subject home (property being appraised) with sold homes (comps) that are similar to the subject property. Appraisal includes at least 3 recent sales within 6 or less months and they have to be within less than one mile to the subject property if no comps can be found from the closest neighborhood. This method is considered the most reliable of all three methods in evaluating single family homes. Because no two properties are exactly identical, each comp must be examined for similarities and differences between comp and the house being appraised. Following are the elements of comparison for which adjustments must be considered:
♦ Location – similar homes may have different values from one neighborhood to another or even between subdivisions within the same neighborhood
♦ Physical features & amenities – size, age, and condition may require adjustments
♦ Market conditions – supply and demand, mortgage interest rates and other economic indicators must be taken under consideration
♦ Conditions of the sale – adjustments must be made for reasons that would affect the sale, for example: a sale between family members or foreclosure
♦ Financing terms – that includes adjustments for the differences such as mortgage loan terms and seller financing
♦ Market conditions since the day of sale – if economic changes occur between the date of sale of comps and the date of evaluation adjustments must be made
Two townhomes in same subdivision, one which sold and the other that is the subject of an appraisal, are very comparable. The comp sold for $160,000 and has a garage valued around $10,000. The subject townhome has no garage, but it has a bar valued at $6000. What is the indicated value of the subject property?
$160,000 the comp (sold)
-10,000 (if comp is better, subtract)
+6,000 (if comp is poorer, add)
$156,000 the estimated value of the subject townhome
This approach is based on the principle of replacement. There are five steps that should be followed in cost approach:
1. Evaluate the cost of the land as if it were vacant and available to be used to its highest and best use
2. Evaluate the current cost of constructing the building and improvements
3. Estimate the amount of accrued depreciation (property’s physical deterioration, functional obsolescence, and external depreciation)
4. Subtract the accrued depreciation (step 3) from the current construction cost (step 2)
5. Now add the estimated land value (step 1) to the depreciated cost of the building and site improvements (step 4) to arrive at the total property value
Current cost of construction = $200,000
Accrued depreciation = $40,000
Value of the land = $60,000
$200,000 – $40,000 + $60,000 = $220,000 this is the total property value
This approach is mainly used for evaluation of income producing buildings (apartment and office buildings, and shopping centers). It is based on the current value of the rights to future income. The assumption here is that the income generated by a building will determine the property’s value. There are 5 steps the appraiser will take for the income approach:
1. Assess annual potential gross income from the building also adding income from other sources like vending machines, parking fees, and laundry
2. Subtract an appropriate amount for vacancy and rent loss to get an effective gross income
3. Subtract the yearly operating expenses from the effective gross income to receive the annual net operating income. Mortgage payments (both principal and interest) are not operating expenses, they are debt service. Capital expenditures are also not considered as expenses. Management expenses are always included, even if the owner manages the property.
4. Determine the rate of return that an investor would like to have for investing his/her capital in this type of income property. This rate is called capitalization rate. The rate is determined by comparing the relationship of net operating income to the sales prices of similar properties that have sold in the current market. Let say as an example, we have a comparable building that is producing an annual net income of $22,000 and was sold for $244,000. The capitalization rate is calculated by dividing net income $22,000 by sale price $244,000 that gives 9%. If other comps sold at prices that produced very similar rate, that 9% is the capitalization rate that should apply to the subject property.
5. Estimate the property’s value by applying the capitalization rate to the property’s annual net operating income. Having capitalization rate and the projected annual net operating income you can estimate the probable value of the property using the income approach. The below formula and its variations are very important in dealing with income property:
a. Net operating income divided by capitalization rate = value
b. Net operating income divided by value = capitalization rate
c. Value times capitalization rate = income
Real estate appraisal methods