Pricing and Appraisal, Part I
(Three Appraisal Methods)
  By Albert Joy

There are three commonly accepted methods to estimate market value—"Replacement", "Income" and "Comparable sales". These are methods used by appraisers to estimate market value, with more weight given to the third method in most instances.

Replacement value approach:
This is the calculation of the cost of land, materials and labor to provide a similar property. THIS IS THE LEAST ACCURATE valuation of the three methods, and is used only in rare occurrences, usually if there is little to no sales activity, or the property is unique to the area. Let’s say there are two homes in a neighborhood, and they are identical, except that one home had some plumbing rupture, and they needed to replace some pipe. The cost of the work was $8,000. What is this property’s worth vs. the first property? The same. Although it cost the owner $8,000 more, there is no increase in value for performing necessary repairs. Who would pay anything for a home that didn’t have running water? If the buyer had to buy the home without the repairs, would they include the cost of the repair in their offer? You bet.

Income approach:
The amount of income a property is able to generate, less its expenses, determines how much debt it can carry. On an income-producing property, a portion of the income from the property can be allocated to help the buyer qualify for a loan. The income approach is more of a substantiating factor, rather than a sole method to determining market value—If the market approach has little data, and the income approach supports the same numbers or better, lenders will take the income approach into consideration as a mitigating factor.

Comparable Sales approach:
The "Market" is defined as what a ready, willing and able buyer is willing to pay for a property sold by a ready, willing and able seller who is not under duress. Appraisers will typically take the last three most similar sales, adjust for differences such as superior or inferior condition, location, size, and timing of the sale, in order to come out with an adjusted estimated value. Although not perfect, this method is the closest to actual value. Appraisers have general guidelines to comply with, including the age of the historical data they are allowed to use. It is also important to note that normal real estate escrow cycles take 30-60 days, so sale data that took place yesterday, is actually already 30-60 days old.

On another pertinent side note, many times uninformed property owners will assume that the tax assessed value reflected on their tax bill is a good indicator of value. This is a dangerous method of valuation, and should never be used in planning a real estate strategy, be it a purchase, sale, refinance or exchange. Either get an appraisal performed, or ask a competent real estate broker to perform a market analysis for you to determine value.

The appraiser’s report is important in the loan process, because the amount of the loan approved is calculated by the loan to value ratio times either a) the contract price, or b) the appraisal report value, whichever is LOWER.

Example: Seller "S" lists their home for sale with a broker at $105,000. Buyer "B" makes an offer to buy the property, at $100,000 with an FHA 3% down loan at a 97% Loan-to-Value Ratio (LTV). The loan would be $97,000. The appraiser can not find supporting sales to justify the $100,000 sale price, and the appraisal comes in at $95,000. The lender can only approve a loan equal to 97% of the $95,000 appraised value, or $92,150. There is a $4,850 discrepancy that must be solved, or the Buyer will not be able to successfully complete the sale.