The Real Estate Appraisal Process

Real estate appraisal is the practice of developing an opinion of the value of real property, usually its Market Value. Real estate appraisal is a service performed by an appraiser that determines valuation (what property is worth) based upon its highest and best use and the use of three basic techniques or approaches to value.

Appraisers

Appraisers are licensed by the state and can be found through your real estate directory, real estate offices, or the bank. Appraisers often work for themselves, but also work for mortgage firms, real estate brokers, lenders, corporations, and government agencies. An appraiser is a professional who has the knowledge and expertise necessary to estimate the value of real estate. They typically work for individual clients and focus on evaluating one piece of real estate at a time, spending much of their time researching and writing reports.

The most critical step in any appraisal is for the appraiser to identify the Highest and Best Use of a given property. This will form the basis for all three valuation approaches or techniques that follow.

Highest and Best Use

Highest and Best Use is that use that will result in the highest value of a property. It will be that use that is physically possible, financially feasible, and legally permitted. For example, if a vacant plot of land is situated along a busy street, is large enough to accomodate a department store, is zoned for retail commercial use, and a new department store could be expected to be successful there, then the highest and best use of that site would be as a department store site. By contrast, suppose that same site has a home on it. If it can be shown that the value of that site is actually greater as a residence than as a site for a department store, then the highest and best use would be as a residence. Highest and best use is all about whatever use gives the property the most value in the marketplace. Once the highest and best use has been identified, the appraiser begins to apply the three basic valuation techniques.

The Cost Approach

The Cost Approach: a set of procedures through which a value indication is derived by estimating the current cost to construct a reproduction of the existing structure, deducting the accrued depreciation and adding the estimated land value. The principle of substitution is the basis of the cost approach, in that no rational person will pay more for a property than the amount for which he can obtain, by purchase of a site and construction of a building, with undue delay, a property of equal desirability and utility. Appraisers typically make use of published cost figures when calculating the cost to construct a building. These sources of data are available online and in printed form. Land value is determined by a comparison of the subject site with other similar sites that have recently sold.

The Income Approach

The Income Approach is typically used in appraising income-producing properties. It is a technique whereby the gross or net income of an income producing property is capitalized at a rate which provides a return of interest on the money invested and a recapture of the capital investment in the improvement over a reasonable term of the investment. Capitalization is accomplished for simple residential properties such as rented homes or duplexes by the use of a Gross Rent Multiplier. This involves multiplying the total monthly rent of a property times a number (GRM) found by dividing the sale prices of similar properties by their monthly rents. Commercial and industrial properties involve more complex formulas to determine their value in the income approach, such as cash flow analysis.

The Sales Comparison Analysis

While cost and income considerations are important, the Sales Comparison Analysis is regard as the industry standard for residential properties. Appraisers get to know the neighborhoods in which they work. To assure that any effects (positive or negative) of its location will be reflected in the sales comparison analysis, the appraiser should select comparable sales from within the same neighborhood whenever possible. If this is not possible, the appraiser may need to make "neighborhood" or "location" adjustments for any sales that are not subject to this same neighborhood characteristic.
For commercial and industrial properties, location within a certain neighborhood may not as important as the characteristics of its specific physical location. A commercial site needs to be in a location that is suitable for the types of businesses that could locate there but also has to be of a suitable size, shape, and have suitable access to customers. For example, a gas station needs to have a site that is large enough and that customers can enter and exit conveniently. As a result, sales of sites that could possibly accomodate a gas station are compared and adjusted to match the characteristics of the subject site.

The same is true of other aspects of a property, such as the size, quality and features of the buildings. Differences that the market reacts to are adjusted in the comparable sales to reflect what is present in the "subject" property that is being appraised. If a sold home features a fireplace and the subject does not have one, but the market considers a fireplace to be important, the appraiser make a downward adjustment to the sale price of the comparable sold home because it did have one and the property being appraised does not. The reverse is true when the home being appraised has a feature that other homes that have sold do not have. The basic question is what features are present in a property that buyers are willing to pay extra to get, or will pay less if it they are not there? When differences exist, the appraiser must determine how much a typical buyer will add or deduct for it.

Final Estimate of Value

Once the appraiser has completed the three techniques, it is time to decide which of them is the most reliable and most closely follows the actions of the market. For residential properties, the Sales Comparison Analysis is typically the most reliable. For commercial or industrial properties, all three techniques (or portions of one or more) may be reliable. The appraiser reconciles the various aspects of each technique into what he or she believes produces a credible and supportable opinion of value. The result is the Final Value Estimate, which, depending on the needs of the client, may be expressed as a single number or a range of value.

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