This article first appeared on the LinkedIn Pulse blog at The Three Musketeers of Real Estate.
I’m not going to go and beat around the bush. You’re buying a home (and most likely taking out a loan, unless you’ve got hundreds of thousands of dollars in your piggy bank), you need an appraisal. You’re trying to get a reduction on your property taxes, you need an appraisal (unless you hire a property tax abatement firm or attorney). You’re selling your home, you SHOULD get an appraisal, lest you list your real estate on the market for too high and it sits there for months or list it for too low and take a painful (and taxable) loss on the disposition. Yes, “appraisal” is just as key a term in the real estate, accounting and finance world as “saute” is in the culinary world.
Anyone who’s had an appraisal done on any type of real property can vouch that appraisals are not cheap. Also, no two appraisals are the same and generally for the average layman, the best way to obtain the most equitable depiction of their real property’s value would be to get multiple appraisals and take the average of data. Nobody wants to do that and most people cannot afford that. So how can you be better sure that you not only hire the right appraiser, but also get the fairest appraisal possible?
The first step is to understand the 3 main types of appraisal methods used by professional appraisers, real estate tax attorneys, valuation companies and property tax management firms:
- The Cost Approach
- The Sales Comparison Approach
- The Income Approach
Keep in mind that this article will not turn you into a professional appraiser, but hopefully will educate you a bit more on the world of real estate investing and real estate valuation. If you are trying to buy, sell, invest in, renovate or abate the taxes for your real property, PLEASE contact a professional. The fees charged will be worth it as opposed to doing it yourself, getting yourself in a pickle and having to spend even more money and resources on legal fees, professional help and more to get you out of your mess. I cannot tell you how many clients come to us with problems that could have been avoided or mitigated had they contacted our firm in the first place and not attempted this themselves.
The Cost Approach
The Cost Approach, which is also known as the Replacement Approach or the Replacement Cost Approach, entails the appraiser taking every quantity and type of supplies and materials, cost of permits, cost of labor, fees and taxes that would be required to construct an exact replica of the real property. They then factor in the land value and subtract any depreciation. The 2 primary methods to the Cost Approach are the Cost New method, which will take into consideration all facets to construct the exact duplicate of the property from new with exact materials or equivalents and the Depreciation method which takes into account the Cost New method as well as the contribution of improvements to the real property. The formula to the Cost Approach, the basic formula you need to understand is Property Value = Land Value + (Cost New – Accumulated Depreciation).
The Sales Comparison Approach
The Sales Comparison Approach is also known as the Sales Comp approach, the Comparable Sales Approach or in commercial real estate, the Market Approach. The Sales Comparison approach is exactly what it sounds like: The appraiser or analyst takes into account similar properties in your area and compare their values to the subject property. This is generally the more popular approach used by appraisers, frankly because it tends to be the easiest. The comparable sales should be as close to the present time as possible, most appraisers like to use a limitation period of 90 days. The sales prices of the comparable properties are generally adjusted to reflect time, conditions and subtle differences between the subject property. The problem with this approach is that it requires an active market for the property type you are trying to appraise. This is easy for residential properties, but for commercial properties that tend to have unique characteristics (most of the time, being that it was designed for the business it houses), this tends to be a bit more difficult.
The Income Approach
The Income Approach, also known as the Capitalization of Income Approach, tends to be the most accurate approach because it utilizes real numbers and quantitative data to determine the value of the real property. The Income Approach is ideal for properties that generate income (such as rental properties or commercial properties), because it determines the value of the property based on the income the property generates. The Income Approach is comprised of 2 primary methods: The Direct Capitalization method and the Yield Capitalization method. Financial professionals compare the Income Approach to the Discounted Cash Flow Analysis, as this utilizes the same projection methods and is ideal for benchmarking.
The Direct Capitalization method is generally the simpler method, but requires comparable sales data in the subject market. The multiplier that will be utilized to compute the respective income summary for the subject property is contingent upon the comparable sales data. The three primary multipliers are:
- Potential Gross Income Multiplier
- Effective Gross Income Multiplier
- Net Income Multiplier
The Yield Capitalization Method tends to be the greater-detailed method, but will give what in real estate law is known as the “proforma” estimates. Proforma is a real estate’s cash flow projection for an income-generating property. As many cash flows are different, the Net Present Value Formula is what is generally used to calculate the property’s value using the Yield Capitalization Method of the Income Approach. In the Yield Capitalization Method, previous quantitative data is taken into consideration and not comparable sales, which makes this the more ideal method for real properties with unique characteristics that may not have ideal comps in the area.
Regardless of the method you use, to understand the Income Approach, you must understand two main components used to arrive at accurate, comprehensive conclusions: The Market Cap Rate and the Net Operating Income.
The Market Cap Rate or the Cap Rate tells you what the average rate of return on a property in a certain geographical location is. The Cap Rates depend on the area and the range of desired percentages vary, but for tax appraisal purposes, a higher cap rate indicates a lower-income area that will most likely have overvalued properties in the area that can qualify for an abatement on their tax bills.
The Net Operating Income is a clear picture of the net income the real property itself generates. The NOI takes into consideration the revenue brought in that is solely attributed to the building itself (not so much the businesses operating in the building, but rental properties in the building) as well as expenses that solely attribute to the building itself (meaning utilities, management, reserves for replacement costs, etc.). The expenses subtracted from the revenues result in the Net Operating Income. For rental properties, the Vacancy Rate is taken into consideration when calculating the revenue, as the Vacancy Rate paints a picture of the occupancy situation of the rental building. High vacancies tend to decrease the value of the real property, which may be ideal in arguing a case to abate property taxes.
In conclusion…
There is no “ideal” or “preferred” appraisal approach for real property valuation. Everything must be analyzed and dissected on a case-by-case basis. However, whether you’re a new real estate investor looking to dip their toes in the exciting and lucrative world of real estate investing or a seasoned property owner, hopefully this article can help you to understand the process that your appraiser goes through to value your property, a bit better. Having this simple knowledge tucked under your belt can drastically increase your profitability, ROI and savings on your real property for many years to come.
Kelsi Chun Lange is the CEO of PVA – Property Value Analysis Inc in Barnstable County, Massachusetts. She holds a BBA in Accounting from the University of Hawaii at Manoa and DeVry University as well as an MBA in Accounting Management from The Keller Graduate School of Management. She lives in Massachusetts with her family, 5 cats and her Pomeranian, Chippi.
Website: pva-inc.com
Twitter: @PVA_Inc
Instagram: @propertyvalueanalysis
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