When determining the market value of a property, there are three methods that appraisers of real estate use. As such, investors are able to make sound investment decisions through logical steps.
Also, appraisals help with financing, sales listing, investment analysis, property insurance, and property taxation. Real estate appraisals are also required to settle down legal matters such as divorce, real estate settlement, or a lawsuit. Understanding real estate appraisal terminology is an important starting point when investing in real estate.
The three real estate appraisal methods performed by a professional certified appraiser or even a real estate investor are:
Sales Comparison Approach
The cost approach bases value on the estimated cost to build an equivalent property. This method involves separate estimates of value for the building(s) and the land as well as construction cost while taking into account the depreciation, such as wear and tear, of the property. The estimates are added together to calculate the value of the entire improved property. The cost approach assumes that a reasonable buyer would not invest in an existing improved property whose price is more than when they purchase a comparable lot and construct a comparable building from scratch. Because the cost approach does not analyze the income it could generate or the selling prices of similar properties, it is beneficial when the property being appraised is a type that is not frequently sold and does not generate income such as schools, churches, hospitals, and government buildings.
As such, appraisers consider the cost approach to be more accurate for new construction or unique properties. It’s also useful for insurance purposes such as in the case of burned buildings, the only question to ask is how much it would cost to replace the building on that spot.
Appraisers may estimate the cost in two different ways:
The reproduction method — looks at what it would cost to build a replica of the building, using original materials.
The replacement method — assumes the new building would have an updated design, use newer materials, and more current construction.
Here’s how appraisers calculate it:
Property Value = Land Value + (Cost New – Accumulated Depreciation).
Real estate professionals may view the cost approach to be less accurate because:
Estimating the value of vacant land can be subjective.
Calculating depreciation on an older property is can be challenging.
Finding comparable materials can be burdensome.
This real estate appraisal method estimates the current value of a real estate property based on the net income it generates divided by the capitalization rate.
Here’s how it’s calculated:
Net Operating Income (NOI) divided by Capitalization Rate
The net operating income is the total amount of income and expenses for the subject real estate property and for similar properties in the same area
The capitalization rate, or “cap rate,” is the rate of return an investor would makeover one year.
It’s calculated in these two ways:
Capitalization Rate = Net Operating Income divided by Current Market Value
Capitalization Rate = Net Operating Income divided by Purchase Price
The first way reflects current real estate market prices by looking at recent sales of similar buildings.
On the other hand, the second way looks at the original purchase price of the property. As a result, if an investor bought the property decades ago when prices were lower, this method is less accurate.
With the income approach, the cap rate and estimated value have an inverse relationship—lowering the cap rate increases the estimated value.
Essentially, the income approach is typically used for income-producing properties because it helps investors understand the potential profit of a property. This real estate appraisal method also helps lenders evaluate the potential risk of financing the property.
Sales Comparison Approach
This the most commonly used real estate appraisal method. To estimate market value, the appraiser considers prices of recently sold properties that are similar and within the same geographic area. This is known as the SCA or Sales Comparable Approach.
Experienced appraisers know how to make adjustments for variations between recently sold properties and the property they’re valuing. Therefore, they take a close look at differences such as building size (square footage), building amenities (number of rooms), age and condition of the building, as well as the size and average price per square foot. The appraiser will then factor them into the estimated value. However, the most important factor is no doubt the location of the property, including proximity to schools, nearby bodies of water, parks, and how close they are to highways and overpasses, as well as pollution levels.
No two properties are exactly alike, so the appraiser must compare similar properties to the subject property. Adjustments are usually needed to account for differences as no two properties are exactly the same. To make proper adjustments when comparing properties, real estate appraisers must know the differences between the comparable properties and how to value these differences. For this reason, real estate professionals commonly use this appraisal method to arrive at a selling price for a property.
To sum up, establishing the value of a property is essential when investing in real estate. Real estate appraisal methods help investors make educated guesses about the potential profit of a property.
Need help with assessing your property? Get in touch with us at Moschetti Law Group. Call 866-603-5521 for a Consultation.
At Moschetti Law Group, our practice serves the needs of Founders by providing real estate law and real estate syndication attorney services to Founders. Whether you are the Founder of a real estate empire or building a business and need assistance with purchase and sales, real estate transactions, or real estate litigation, we serve Los Angeles County, eastern Ventura County, and North Orange County from our office in Calabasas. We also have a primary focus on helping Real Estate Syndication Founders throughout the United States with forming their syndication, understanding crowdfunding, private placement memorandums, and operating agreements.