A home purchase is the largest, single investment most people will ever make. Whether it's a primary residence, a second vacation home or an investment, the purchase of real property is a complex financial transaction that requires multiple parties to pull it all off.
Most of the people involved are very familiar. The Realtor is the most common face of the transaction. The mortgage company provides the financial capital necessary to fund the transaction. The title company ensures that all aspects of the transaction are completed and that a clear title passes from the seller to the buyer.
So who ensures that the value of the property is in line with the amount being paid? The buyer and lender are both at significant risk without a professional estimate of the property's value. An appraisal is an unbiased estimate of the most likely price a typical buyer would to pay for a parcel of real estate, where both buyer and seller are informed parties. To be an informed party, most people turn to a licensed, certified, professional appraiser to provide them with the most accurate estimate of the market value of their property.
So what goes into a real estate appraisal? It all starts with the inspection. The appraiser will inspect your property much like a typical buyer, and identify all the factors that have an impact on value. The inspection usually includes measuring the exterior of the home to determine it's total living area, and measuring any other structure that has contributory value. The appraiser will then take photos of the exterior of your home from all angles, the interior of each room, and any other features that have a positive or negative influence on value (such as a swimming pool, a large outbuilding, or traffic influence). The appraiser will also obtain all pertinent information from county records regarding the property, such as year built, site size, and any positive or negative easements associated with the site.
Once your property has been inspected, an appraiser uses up to three approaches to determine the value of your property: a Sales Comparison Approach, a Cost Approach, and often in the case of a rental property, an Income Approach. Click on the tabs above for an explaination of these valuation methods.
The Sales Comparison Approach is by far the most applicable method in estimating the value of a residential property. This method most accurately reflects the actions of buyers and sellers in your market sector. In this method, the appraiser identifies the most recent sales in your home's neighborhood or expanded marketing area that are similar to your home. These sales are usually refered to as "sales comparables", "comparables", or "comps". Adjustments are made to each of their sales prices to reflect what each comparable would have sold for if it were the same as your property in each aspect. For example, a smaller home is adjusted upward to reflect what it would have sold for if it were the same size as your home. A much newer home may be adjusted downward if it is superior to your home in overall condition. All adjustments are extracted from historical sales in the market to reflect the actions of a typical buyer. This means that adjustments often do not reflect the actual cost of each feature. After all adjustments are made, the appraiser then reconciles the range of adjusted sales prices to a single value.
The Cost Approach is probably the easiest valuation method to understand. This method can accurately reflect the cost of replacing your home with a new home of similar quality, size, and function by estimating the value of your site, and adding the cost of constructing a similar home. If your home is not brand new, it will be necessary to estimate the physical depreciation in the home, and subtract this from the total.
The Cost Approach is often a good way to estimate the value of a new home. However, if your home is not nearly new, or has not been remodeled to the level of a new home, this method is less appropriate than the Sales Comparison Approach due to the inaccuracies of estimating physical depreciation.
In the case of income producing properties - rental houses for example - the appraiser may use a third approach to valuing the property, the Income Approach. This method employs the use of other rental properties in the area that have sold to establish a ratio of value to rent (ie. Sale Price/Rent). This factor can then be multiplied by the market rent of your property to estimate its value (Value = Sale Price/Rent x Mkt Rent). Keep in mind that market rent may not be equal to the rent you are charging for a variety of reasons (long term tenant, rented to relatives, etc.) This method is generally only applicable when the vast majority of homes in a neighborhood are purchased for their income producing capability.
Combining information from all approaches, the appraiser then forms an "Opinion of Value". This is the appraiser's best estimate of what the property would most likely sell for under normal market conditions. In the case of a purchase, the value opinion may not always be equal to the agreed upon sales price. This occasionally happens when a property is sold to a relative, or is unique in the area and there have been very few sales of similar properties. However, a lending institution cannot lend more than can be justified by the recent marketplace. This requires a well supported valuation by a professional appraiser who is experienced and knowledgeable in the local area.