Although appraisers use three basic “approaches” to arrive at their professional appraisal of a property’s market value, not all methods are appropriate for each property. But in some situations, all three approaches are used.
Here is a look at the most common methodology used by appraisers:
1. REPLACEMENT-COST APPROACH. This appraisal method usually involves multiplying the square footage of the structure by the current construction cost for comparable quality to arrive at the estimated replacement cost of a building. When using this method, the key to success is starting with an accurate source of current local construction costs, such as home builders Marshall & Swift, and the Bluebook.
The next step, probably the most difficult for an appraiser, is to estimate applicable depreciation for an older structure to arrive at a reasonable replacement cost-estimate. The land value, based on cost per square foot, is then added to arrive at the property’s total market value.
Insurance agents often use the replacement-cost approach to arrive at recommended replacement-cost insurance coverage for houses. Although used as a crosscheck, most appraisers and mortgage lenders don’t pay much attention to the replacement-cost approach for all but newer residences.
2. RENTAL-INCOME APPROACH. This appraisal method is most appropriate for rental-income property, such as apartment buildings, shopping centers, office buildings, warehouses and other rental structures. If the property is owner-occupied, such as a warehouse, then rents for equivalent nearby rental property are used with this approach.
The net income, minus a vacancy estimate, is capitalized (based on the local capitalization rates for recent sales of similar income properties) to determine the estimated market value of the subject property. Appraisals of single-family houses and condos do not usually include this method unless the neighborhood is primarily occupied by tenants rather than owner-occupants. Even when a house is used as a rental, this is usually not the best appraisal method because the market value of most residences is determined by recent sales prices of comparable nearby houses, not their rental income.
3. COMPARABLE SALES-PRICE APPROACH. This is the most important appraisal method to determine the market value of a house or condo. To be accurate, the sales prices of comparable nearby residences should be as recent as possible. Sales prices more than six months old are usually not used unless there have not been any more recent home sales in the vicinity. In a rising or falling market, comparable closed home sales within the last three months are preferred.
Because this is the most important appraisal approach for houses and condos, the experience of the appraiser becomes critical to determine what is a truly comparable similar nearby residence. However, adjustments must usually be made to both the “subject property” being appraised when comparing it to the comparable nearby home sales, and to the comparables, to compensate for the pros and cons of each residence.
To illustrate, if the subject home has three bedrooms, but all the recent “comps” have four bedrooms, the appraiser must subtract value for the lack of a fourth bedroom. But if the subject property has a family room and the comps lack family rooms, then the appraiser will add value to the subject property.
The critical part of the appraisal process is the appraiser’s addition or subtraction of value, often involving thousands of dollars, based on his or her expert valuation judgments. Square footage of the subject property and the comps also play a big role because the appraiser usually has not seen the interior of the comparable properties.