The Different Approaches to Appraisals

In This Article

• Approaches to Determining Value
• Market Comparison Approach
• Cost Approach
• Income Capitalization Approach
• Appreciating Concepts: Cap Rate 4
• Confirming and Adjusting the Numbers
• Boost Your Bottom Line Using GPARENCY
• FAQs
  • About the Author

When investing in a property or serving as a mortgage broker, you must have accurate and professional property appraisal procedures to ensure a smooth financing process. When determining the value of a property, it is essential to use clean methodology and reliable sources of data to come up with an informed assessment. Knowing the methods and procedures involved in proper appraisals will help you oversee the process with ease and determine how viable a potential investment is. 

First, let’s start by defining what an appraisal is. An appraisal is a professional estimate of the value of a property. Appraisals are crucial for the purchaser and the seller to arrive at a reasonable offering price. Lenders, too, rely on appraisals to ascertain a property’s present and future value to determine the risk in lending on a particular property and calculate the loan amount.

Approaches to Determining Value

There are three methods commonly used in appraising properties. An independent fee appraisal service will include the value indicated by each of the three methods in its report. A buyer will typically bid somewhere between the lower and the higher result of the methods. When ordering an appraisal for a loan, some banks will favor one method over another, and some just use the method that yields the lower amount.

The three methods are:

• Market Comparison Approach
• Cost Approach
• Income Capitalization Approach

Market Comparison Approach

This is sometimes called the Market Data Approach. The market comparison approach determines value by comparing recent real estate sales prices in the area of the property being appraised. The properties used for comparison must be similar in type, size, age, and condition. For example, the recent sale of a million-dollar apartment building in the Bronx, NY containing twenty units, dictates that a similar building in that market, having the same amount of apartments, will also be valued at one million dollars.

In the case of residential properties, this is a relatively easy task. There are usually enough recent sales in a given neighborhood to work with and plenty of comparables or near comparables. Finding comparables is a much more difficult task for commercial properties.

Commercial sales are comparatively less frequent than residential sales and typically have many more variables in their physical and financial setup details. For example, an appraisal is sought for a 5,000-square-foot, 10-year-old suburban retail complex, situated in a poor location for retailers, having five tenants, each with different lease renewal dates. To use the market comparison approach, it is necessary to find a direct comparable sold recently enough to be an indication of the present market. In many cases, this is simply impossible. Instead, an appraiser must come up with sales that are as close to the conditions of the appraised property as possible and then make adjustments to take into account differences such as the timing of the lease renewals, location, and age of the buildings.

Cost Approach

The cost approach calculates the value of a property by estimating the amount it costs to rebuild a building from scratch at current prices (replacement cost) and then adding the current value of the land. To appraise a 15-year-old factory building situated on a 10,000-square-foot lot, the following calculations would be made:

The total cost to construct a factory building similar to the one on the lot, including material and labor, is $1,000,000, or $100 per square foot.

The value of the land itself, without any building on it, is $500,000, bringing the total costs to $150 per square foot. You now have a value of $1,500,000 ($150 x 10,000 sq. feet).

However, one more adjustment must be made before arriving at the final value. The calculation above gives you the amount it would cost to build a brand-new building. However, the building that you are actually appraising is 15 years old. The appraiser must estimate an amount that represents the 15 years of physical deterioration and subtract that from the final value.

In addition to physical deterioration, other factors must be adjusted for when comparing a new building and an older one. For example, this factory’s manufacturing product may be being produced more efficiently today with an upgraded design or technology that the present building does not support.  This functional obsolescence is estimated, given a dollar figure, and subtracted from the final value.

Hence, reproduction costs + site value, less physical deterioration and functional or economic obsolescence = value indicated by the cost approach.

Income Capitalization Approach

This approach applies the Capitalization rate (Cap rate) to the Net Operating Income of a property to arrive at an appraised value. In today’s environment, this is the most common way of determining value and is typically considered the most important method for appraising apartment and office buildings, hotels, and shopping centers.

Before illustrating the application of this approach, let me explain what a cap rate is, how it is calculated, and what it indicates.

What is the Cap Rate?

The cap rate is the annual return on the total investment into a property, expressed as a percentage. It is arrived at by dividing the return of the building (before mortgage payments and income taxes) by the total price of the building. This includes both the down payment and the amount loaned by the bank. For example, a building with an NOI of $72,000, and a market value of $1,000,000, has a cap rate of 7.2%. This means that the building produces 7.2% of its value in profit every year.

Applying the Cap Rate

In the above example, we have used the NOI and the known market value to arrive at a cap rate. When using the cap rate approach to appraising a property, the reverse is done. A cap rate is determined for a particular area. This is done by looking at recent sales of comparable properties in relation to their NOIs, as above. For example, if comparable buildings with NOIs of $90,000 sold recently for $1,000,000, then this translates into a cap rate of 9% (or, “a nine cap”) for that market.

This cap rate can then be applied to the NOI of the building being appraised to arrive at a value. Thus, the estimated value of a building whose NOI is $250,000 in a market with a cap rate of 9% is $2,777,777 ($250,000/.09).

Variation

A simpler version of the income capitalization approach is the multiple income approach, in which the price of the building is expressed as a multiple of the gross annual income. Thus, if in a particular market, properties are selling for five times the rent (five times the total income from rentals), a building with an annual income of $200,000 will be priced at $1,000,000. This variation became the accepted method in certain markets due to the simplicity of its calculation.

Appreciating Concepts: Cap Rate 4

In the real estate market, the cap rate is used as a barometer of how secure the property and location are in a particular market. The rule is that the lower the cap rate, the higher the level of security, and the more value the property has. While this may initially sound counterintuitive, some reflection will show why this is true.

Consider this example:

A shopping district has a cap rate of 7.2%. This means that buildings on the market now for $1 million produce $72,000 a year in net operating income. If the neighborhood becomes more trafficked and thus starts producing more income, the NOI of the building will go up. However, this by itself will not change the cap rate. Although the NOI is higher, the building now becomes more expensive because of its higher income. Conversely, if the profits of a given area go down, the prices of those buildings will also decrease. This market adjustment will ensure that the cap rate, which is the ratio of the NOI to the overall cost of the building, will remain more or less constant.

The factor which does affect the cap rate is investment security. It is a basic principle of investing that the higher the risk of a given investment, the lower the price of that investment. Conversely, an investment that is very secure will be more expensive since there is less doubt that a profit can be made. In real estate, investors are willing to pay comparatively higher prices for a lower annual return in an area that is a secure investing environment. In time, the long-term value will outpace the smaller return. Thus, a low cap rate is an indication of an area in which investors are willing, because of its stability, to accept lower NOIs for more expensive properties. Consequently, while an average shopping district in a healthy market may have an average 8% cap rate, Manhattan, which is a consistently secure area of investment, has an average cap rate of around 4.5%.

Confirming and Adjusting the Numbers

The actual job of the appraiser starts well before these formulas and methods can be applied. An appraiser must confirm that all the income and expense numbers that he is given are indeed accurate. The appraiser verifies these numbers by looking through the leases, bills, and city tax records.

After all the relevant numbers of a property are verified, the appraiser must then make adjustments for the prevailing market conditions. Even if an apartment is fully occupied, it is still appraised as having the vacancy rate of the neighborhood in which it is situated. This is because the local market of the building is usually a better indicator of future vacancy than the building’s present occupancy level. Similarly, an appraiser looks at what comparable buildings are collecting for rent per square foot and their various expenses.

It is important to remember that these are not rigid formulas. In making these comparisons, an appraiser will take into account any aspects of the building which make it unique. For example, suppose it can be argued that the reason that this building has a lower vacancy rate is its lower rent or better upkeep. In that case, the appraiser may only apply a percentage of the market vacancy.

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FAQs:

1. How long will it take to appraise a property?
   • The length of time it takes to complete a real estate appraisal can vary depending on a number of factors, including the complexity of the property, the purpose of the appraisal, and the availability of necessary data.
     
     In general, a standard residential appraisal can take anywhere from a few days to a few weeks to complete. This includes the time it takes to schedule the appraisal appointment, perform the property inspection, research and analyze the relevant market data, and prepare the final report.
     
     For commercial properties or complex properties, the appraisal process can take longer. Appraisals for commercial properties may require additional research and analysis of income and expense data, as well as other market factors that can impact the property’s value.
2. How do I find a good appraiser?
   • Finding a good appraiser can be an important part of the real estate valuation process. Here are some steps to help you find a good appraiser:
     • Check for licensing and certification: Look for appraisers who are licensed or certified by a recognized appraisal organization, such as the Appraisal Institute or the American Society of Appraisers. These organizations have strict standards for education, training, and ethical conduct.
     • Look for experience: Look for appraisers who have experience appraising properties similar to yours. For example, if you’re getting an appraisal for a commercial property, look for an appraiser who specializes in commercial properties.
     • Check for reviews: Look for online reviews of the appraiser or ask for references. You can also check with your state’s appraisal licensing board to see if there have been any complaints filed against the appraiser.
     • Ask for credentials: Ask the appraiser for their credentials and qualifications, including their education, training, and experience.
     • Consider their availability and pricing: Make sure the appraiser is available to complete the appraisal within your timeline and that their pricing is reasonable.
     • Ask for a sample report: Ask the appraiser for a sample report so you can see the level of detail and quality of their work.

By following these steps, you can help ensure that you find a qualified and trustworthy appraiser to value your property.