What you should know about real estate appraisal methods
In addition, appraisals help with negotiations, taxes, insurance and lending. Understanding real estate appraisal terminology is an important starting point when investing in real estate.
The three real estate appraisal methods are:
- Cost Approach
- Income Approach
- Comparable Approach
The cost approach bases value on the estimated cost to build an equivalent building. This includes the cost of the land, the cost of construction, minus depreciation.
This real estate appraisal method calculates how much it would cost to replace the building today. It does not analyze the income it could generate, or the selling prices of similar properties.
For these reasons, appraisers consider the cost approach to be more accurate for new construction or unique properties. It’s also useful for insurance purposes.
Appraisers may estimate the cost in two different ways:
- The reproduction method — looks at what it would cost to build an exact replica of the building.
- 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 = Replacement or Reproduction Cost — Depreciation + Land Value
Real estate professionals may view the cost approach to be less accurate because:
- Determining the value of vacant land can be subjective.
- Calculating depreciation on an older property is difficult.
- Finding similar materials can be a challenge.
This real estate appraisal method estimates the value of a property based on the income it generates.
Here’s how it’s calculated:
Net Operating Income divided by Capitalization Rate
The net operating income is the total amount of expected rents minus all the expenses of managing the property.
The capitalization rate, or “cap rate,” is the rate of return an investor would make over a one year time period.
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.
Essentially, the income approach 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.
This the most commonly used real estate appraisal method. To estimate value, the appraiser looks at the recent selling prices of similar properties in the area. This is known as the 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, building amenities, land size, etc. and factor them into the estimated value.
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.