Appraisers go through a detailed sequence of steps to arrive at a single value for a home that is in accordance with USPAP (Uniform Standard of Professional Appraisal Practice). This post is not intended to be a comprehensive list and meant to just provide an overview of the process of appraising.
Appraisers utilize the following three methods to arrive at a value: Sales comparison approach, cost depreciation approach, and the income capitalization approach.
That being said, the sales comparison approach is the most common approach utilized by appraisers and requires a small number of comparable sales to produce a single estimate of value. This approach makes two assumptions: 1.) market price is evidence of market value 2.) an informed buyer will not pay more for a property that is equally desirable. Appraisers using this approach will have to adjust prices to estimate the property’s value since every property is unique and heterogeneous in nature. The data available for such approximations are small and is a challenge to every appraisal. Using this approach requires finding sales of properties that are comparable to the subject property meaning it must involve a sale with the same property rights (i.e. fee simple) and parties involved in the sale do not have influence over the other as in transactions between family members or business partners. The elements of comparison consist of transactional and physical property traits.
Transactional traits include financing terms, condition of sale, market conditions, and location. The appraiser determines whether the financing on a sale was typical or atypical and adjust accordingly. They also determine the condition of sale by making sure that the sale being used for comparison did not occur due to abnormal conditions such as a foreclosure, short sale, or a transaction between family members. They also determine whether the market conditions were superior or inferior at the time of the transaction and adjust accordingly. Any personal property such as furniture that were included in a transaction are deducted from the sales price. The proximity to employment, schools, shopping, and recreation are among the factors of location that are taken into account.
Physical traits that may require adjustment include age and condition, size (i.e. square footage), number and size of rooms, quality of construction, age and condition of mechanical systems, age and condition of the roof, functionality of the floor plan, and amenities such as fireplace, pool, and landscaping. Adjustments are made to the comparable properties being used in the appraisal to make them similar to the subject property.
In utilizing the cost depreciation approach, the subject property is compared to a new duplicate of itself by separating the value of the land and building. All elements of comparison are held constant with the exception of age which is measured in terms of accrued depreciation. This approach tends to be more accurate as the subject property becomes newer and useful when the subject is in an area with low market activity. In this approach, the appraiser estimates the reproduction costs then estimates the amount of depreciation from physical deterioration, functional obsolescence, and external obsolescence. Then they estimate the value of the site and its highest and best use. The appraiser comes up with a value by adding the estimated value of the site to the the depreciated cost. Insurance companies rely on this approach since they do not insure the land in a typical property insurance policy. Accountants also rely on this approach to estimate depreciation for tax purposes.
The final approach utilized by appraisers is the income capitalization approach which is obviously most suitable for income producing properties such as a rental home or a small retail center. The appraiser must estimate the subject’s market rent by locating comparable rentals in the subject’s area. Then they analyze transactions to come up with a gross rent multiplier which is the ratio between a property’s gross monthly rental income and the sale prices of the property. In the final step is to multiply the derived market rent with the market derived gross rent multiplier to indicate a value for the subject.
Only when these steps are completed, the appraiser assigns a single value to the property being studied. That’s all folks.