Articles
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Understanding
Appraisals
There are three basic types of appraisals: sales
comparison, cost, and income capitalization.
* Sales Comparison: the sales comparison method
estimates a property’s value by comparing
it to similar properties that recently sold in the
area. Those properties are called comparables, or
“comps.” An appraiser will compare “comps”
to the subject property to help determine its value.
Sales comparison appraisals are typically used to
evaluate single family homes, townhouses, and duplexes.
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Appraisers are generally required
to compare the subject property to at least three
comps. Since few houses are identical, the appraiser
will adjust the values according to some standard
formulas: for instance, if the subject property
has a deck and a comp does not, the appraiser will
adjust the value of the subject property upwards
to compensate for the additional feature. Sales
comparison appraisals are part “art”
and part “science”: the appraiser has
a fair amount of latitude within which to determine
the value of the property. If two different appraisers
evaluate a particular property, they’ll rarely
agree exactly on its value.
* Cost: the cost method determines a property’s
value by calculating how much it would cost to replace.
The appraiser estimates the value of the property
if it was new, then deducts an amount for depreciation
(wear and tear) based on the property’s current
condition. The value of the land is determined by
using recent sales of comps. (There is no way to
estimate land value by the cost method since land
can’t be “replaced.”)
Cost appraisals are more accurate when the property
is fairly new, since it’s easier to estimate
the replacement cost. Cost appraisals are also useful
when a property is somewhat unique and suitable
comparables can’t be found.
* Income capitalization: income capitalization appraisals
place a value on a property based on its ability
to produce income. Income capitalization appraisals
are most commonly used to estimate the value of
office buildings, commercial real estate, and other
rental properties. Very seldom is an income capitalization
appraisal done by an appraiser; they’re done
by investors. In effect the investor is determining
how much they’re willing to pay – which
becomes what the property is worth (to them.) You’ll
see
why investors perform this calculation in a moment.
Since determining value by the income capitalization
method is something you’ll need to be able
to do, let’s look at it more closely. The
process is simple: first calculate the gross income
(rent) for the property and then subtract an amount
for typical operating expenses like loan payments,
taxes, maintenance, insurance, and other costs.
The result is the net income the property is expected
to provide.
Let’s use the following example:
Gross income $50,000
Expenses $40,000
Net income $10,000
You’ve calculated that the property will produce
$10,000 per year in net income. Now you can decide
how much you’re willing to pay for the property.
You can calculate the value by using the formula:
Value = net income / capitalization rate
The capitalization rate is the expected rate of
return. Let’s say in this case you want to
get at least a ten percent rate of return; if you
don’t, you’d rather invest your money
elsewhere. The math is easy:
Value = $10,000 / 10%
So, the value of the property to you is $100,000.
That’s the most you can pay in order to get
a ten percent rate of return. In effect, then, that’s
the property’s value – to you, at least.
Say you’re willing to accept a 7 percent rate
of return. Here’s the formula:
Value = $10,000 / 8%
The value of the property is now $125,000. That’s
the most you can pay in order to receive the seven
percent rate of return you want.
As you can see, an appraiser isn’t the right
person to perform an income capitalization appraisal
– the appraiser doesn’t know what rate
of return you are seeking. The appraiser can perform
a cost approach appraisal to provide a different
view of the property’s value, but if you’re
investing for income, the income capitalization
approach is the only way to be sure you’ll
get the rate of return you seek.
Appraisals are important to buyers, sellers, and
lenders. Lenders use appraisals to make sure they
don’t loan more than the property is worth.
Sellers use appraisals to make sure they aren’t
over-paying for a property and buyers use appraisals
to help them properly value their properties for
sale. Understanding appraisals will make you a better
real estate investor. |
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