By RYAN TAYLOR

What exactly does an appraisal mean?

Perception doesn’t always equal reality. The perception is that an appraisal represents the most accurate value of a property. The reality is that it’s a value provided by a licensed professional, given the purpose and functional use of a property on a given day. The key in that statement is “on a given day.”

While appraisals are indeed very thorough evaluations of a property, they’re not always the most accurate valuation, since they often don’t take into account all the inputs required to derive the current and future value of a home.

An appraiser uses three separate approaches to derive a property’s value:

(1) Sales Approach
(2) Cost Approach
(3) Income Approach

The Sales Approach is similar to comparative market analysis, or CMA, performed by a real estate broker. The appraiser examines comparable (ie, similar) sales and listings from the last 6 months in order to come to a value conclusion. Typically, sales are weighted more than listings, since sales are actual transactions and represent a home’s true resale price, while a listing is simply what a seller hopes to get.

Comparables must conform not only with respect to the subject property itself, but also in neighborhood characteristics. 3 bedroom, 2 bath, 2500 square foot homes on opposite sides of town often sell for very different amounts. Comparables should be within 1-mile of the subject property, but this rule is far from set in stone, as certain neighborhoods dictate a narrower — or wider — radius of comparison.

In the Cost Approach, the appraiser examines the dimensions of the property and structure to determine how much it would cost to duplicate the same home on an identical lot. This is often referred to as “replacement cost.” While this is a useful method for certain types of properties, it’s rarely the most accurate for residential real estate — especially in a volatile market such as we’re currently experiencing.

In the Income Approach, the appraiser determines how much income can be generated from the property and a value is derived from this number. The appraiser usually projects into the future and assumes some ongoing stream of income, discounting the value of that cash flow for the time value of money.

The concept of the time value of money assumes (basically), that most investors would rather receive a lump sum payment now than many smaller payments over time, since inflation causes money to be worth less in the future. Of course, all bets are off during deflation, but that’s another topic for another day.

More often than not, the value of a single family residence is reached through the use of the sales comparison approach.

In reality, the sales comparison approach is effective in providing a well researched value, but it fails to utilize all necessary inputs. While comparable sales are very important to the value of a home, the comparable listings can be — and sometimes are — more important.

We like to view comparable listings as an upper bound for a property’s value, especially in a declining market. For example, if all comparable sales sold 3 months ago for $500,000 and there is a comparable listing is now on the market for $450,000, the listing is far more important than the sales. To ignore the listing and rely on the sales would be inaccurate.

Equally important is the concept of affordability, which is rarely used by appraisers. If there have been very few comparable sales in the past three months, affordability will be increasingly important when trying to understand how much buyers can afford. Weak demand indicates few willing and able buyers in the market, so evaluating prevailing income levels in a particular area help determine whether values are set for small declines, steep declines, or may be approaching stabilization.

Finally, mortgage and credit market conditions — especially now — are very important to the value of a home. In today’s lending world, you need a down payment, good credit and a strong employment history to get a loan. There are plenty of areas where the qualified buyer pool is very shallow. Appraisers don’t put a lot of weight into this fact. 3 sales in the last 6 months means a very different thing if last year there were 30 during the same time period, or just a handful.

While the sales approach does have value, it could be more comprehensive.

A crucial point to understanding appraisals is that the value is today’s value, saying nothing for tomorrow. The reality is that this is an appraisers job; they are not forecasters.

In the current market place, the appraisal can, and some would argue should, be considered irrelevant 30 days after the completion date. When markets can drop upwards of 5-10% in a single month, an appraisal that’s a month old isn’t worth the paper it’s printed on.

However, since the appraisal is still considered by the housing industry to be the most accurate representation of a home’s value, always look at the completion date to determine what lenders and investors believe a home to be worth on a given day. Whether you like it or not, this is the value on that day.

Is the process of reaching an appraised value the most defined valuation process in today’s marketplace?
Definitely.

Is an appraisal the most accurate process to determine the true value of a single family residence? Maybe.

Is an appraisal a projection of what the value of the property will be in the future? Absolutely not.

Tags: APPRAISAL, CMA, comparable, cost approach, forecast, home, house, Housing, income approach, real estate, sales approach, value

This entry was posted on Wednesday, December 17th, 2008 at 2:28 am and is filed under Property Valuations, Real Estate. You can follow any responses to this entry through the RSS 2.0 feed. You can leave a response, or trackback from your own site.