Like beauty, value is in the eye of the beholder. However, for better or for worse, most banks and lenders involved in real estate lending do not see it that way. They require a systematic evaluation of the market value of a piece of property before they will agree to lend against that value. The document that provides them this evaluation is called an appraisal. An appraisal can make or break estimation for any type of real estate deal.
There are different appraisal methodologies for different types of real estate. Investment real estate is often valued under the Income Approach. This is a formulaic appraisal method that divides the anticipated income from the property by the capitalization rate. Difficulties come from determining the correct value for each part of the formula. For residential real estate, however, the Sales Comparison Approach (SCA) is the most commonly applied method.
Elements of the Sales Comparison Approach
As the name implies, this approach compares the value of a property to other properties that have sold recently. Only actual sales that have closed can be considered. There is typically a geographic and time limit on “comps”, as they are called. If a property exactly like the appraised property has sold recently, the job of the appraiser is straightforward. However, this is rarely the case. Skill is required to adjust the sales price of the comps. Appraisers have to account for features either in or missing from the appraised property.
For example, an appraiser would deduct if the comp has an attached two car garage and the appraised property has a detached one car garage. Naturally, there is some estimation involved in determining the value of a garage being attached to the house. Similarly, if the appraised property has a finished basement while the comp does not, an estimated value will be added to the appraised property.
Residential real estate appraisals typically include three comps if at all possible. Each will require adjusting the value of the appraised property for some features. This process results in a range of estimated market values for the appraised property. The appraiser then applies some professional judgment and arrives at a market value. A lender relies on this valuation to decide if there is sufficient collateral to make a loan.
Shortcomings of the Real Estate Appraisal
Until there is a willing buyer with the financial resources to close the sale, there is no way to tell how much a particular piece of residential real estate is worth. A single family home located across the street from a highly regarded elementary school is worth more to a family with children than a retired couple. It may be worth even more to a teacher who has just been hired to teach at the school. An appraisal cannot possibly reflect this type of variable.
In addition, prior to the collapse of the real estate market in 2008 many appraisers colluded with the buyers and even lenders. Appraisers documented market values specified by the buyer or lender. This was clearly unprofessional and unethical. However, because lenders rely so heavily on appraisals in making loan decisions there is still pressure on appraisers to deliver the “right” valuation. Professional standards and comparable sales similar to the appraised property are the best safeguards to a good appraisal.