We all know that an appraisal is an estimate of value at a certain point of time. These are commonly used in real estate as a piece of the puzzle for any given real estate deal to determine market value (market value being what a person that is knowledgeable of the market would pay for a property) and more importantly, profit.
The first point to remember is that an appraisal is an estimate of value at a certain point of time. A certain point of time. The longer in the past an appraisal was done the less weight it carries. Appraisals as recent at a couple months could be completely obsolete depending on the climate or your farming market. As soon as an appraisal in done it starts to depreciate in merit. If you are looking at any appraisal, make sure you note the date and factor in changes that have happened since.
I’ve broken down the different types of appraisals with examples so you can make sure you are getting the right job done for your needs and getting your money’s worth and knowing how to use that information.
3 Types of Appraisals.
Cost approach is when we figure out the replacement cost of a property. Not to be confused with the reproduction cost. Building codes, standards, bylaws, specifications and materials evolves over time so direct replacement might not be possible. Reproduction with modern factors can be. So if we are getting a cost approach on an old property there would obviously be new modern construction to the same specifications. First land value is determined, then reproduction cost of the structure “the bricks and sticks” then depreciation and time are factored in.
This is the best approach for new properties simply because nobody would pay more than the cost of the land, bricks and sticks. These are also perfect for insurance companies to determine how much they need to cover someone and calculate premiums.
ENTREPRENEURS AND INVESTORS DON’T WORRY. These are not the enemy. These appraisals DO factor in job creation, construction mark up and investor profits. It would be pretty anti productive if they did not.
2. Direct Comparison Approach
This is exactly what it sounds like. An appraiser would look at previous sales of similar properties in the market and adjust for time. Professional appraisers use what is called a benchmark home price as a base line. This is different form median or average house price because those two stats can be skewed with circumstantial overpriced or underprices sales. This benchmark is created by local real estate boards by tracking how much average home values are and how they have increased or decreased over time to arrive at a range. Then they will look at typically 6-7 properties, adjust for value differences like a garage, a new roof, or square footage to arrive at a specific value.
This type is the most common for residential properties because it’s easy to do and it more accurately reflects what buyers and sellers are actually doing in the market place.
This is obviously used for income producing properties like commercial buildings, industrial structures or multifamily dwellings. This value is determined by the annual stabilized net income of a property minus expenses and then factoring other factors like reproduction cost, risk, comparable buildings and more. This can also be simply expressed by net operating income (NOI) divided by the capitalization rate. Capitalization rate (or cap rate) is expressed in a percentage. If a property was listed for $1,000,000 and generated an NOI of $100,000 annual net, then the cap rate would be $100,000/$1,000,000, or 10%. Or if a property nets $700,000 annually with a cap rate of 8%, the value would be $8,750,000. Risk also becomes a factor to this cap rate. The higher the risk the higher the cap rate and the lower the value. Residential properties tend to have a lower cap rate because people will always need a place to live. This is in contrast to a building designed to be a cheese factory. More specific build, more risk, higher cap rate, lower value.
I good example where this appraisal approach would apply is a strip mall. Would you care about comparable malls structures? Or how much it would be to rebuild? Or would you want to know how much income is being generated against what it’s going to cost you?
Every deal is different and every approach has its place. You may use one, all three or any combination of two to make sure you have done proper due diligence for you and your partners.
I hope this has shed some light on the next phone call to your appraiser.