Real estate appraisal and valuation are incredibly important not only for the real estate exam but for your real estate career. Understanding real estate appraisal and valuation can not only give you an advantage when you become an agent but make the real estate exam much easier!
How Much Real Estate Appraisal and Valuation Concepts Are On The Real Estate Exam?
Regardless of what state you are taking your real estate exam in, there will be appraisal and valuation concepts. It’s a fact; appraisal and valuation will show up. It’s hard to give you an exact number since every state varies. However, on average, our data suggest that anywhere between 5 to 15 appraisal and valuation questions are on each state’s real estate exam.
Since 5 to 15 questions can be a large margin, it’s best to be as prepared as possible, especially since every right question is as equally as important as the next on the real estate exam.
Do Real Estate Agents Appraise Property?
Normally no. Unless they are also a licensed appraiser, while agents will typically not be doing property appraisals, it’s still essential to know what you are talking about. The worst thing an agent can do is come off as uneducated or underprepared.
Real estate agents must know things like understanding the techniques involved in the appraisal, how deprecation and value work, and comparing appraised value to market value.
And…. of course, luckily for you, we put together this guide on real estate appraisal and valuation to make your life much easier! So whether you’re studying for your real estate exam, are already an agent, or are just interested in appraisal you’re in the right place.
Real Estate Appraisal and Valuation
Appraising is a distinct specific area within the world of real estate. The fascinating part about appraisal is the different approaches people take. There are various appraisal methods depending on where you live and who you talk to.
Before we get into the appraisal itself, we have to determine what is value. For some, value is how much something is worth; for others, it may be how much something costs. Value stems from the fact that things have worth. While the cost of your phone maybe $500, the photos in it may be priceless. Value is different for everyone and can be very challenging to determine. Luckily there are ways to assess the value of property and homes.
Market Value and Market Price
You’ll hear a lot of people use the word Market Value or Market Price. This just means the actual selling price of the property. So if your home sells for $200,000, its market value is $200,000.
Appraised Value vs Market Value
It’s worth noting that appraised value is different from market value. Most properties do not sell for the appraised value; often, properties sell below or above the appraised value. So what’s the point of finding an appraised value? Well, the appraised value is what lenders use to help them minimize the risk of lending and is still a basis for finding a market value.
The appraiser is hired to determine the property’s baseline market value, not the property’s final sales price. And while earlier we established those two things can be the same, more often than not, they aren’t. There are different degrees and levels of value, meaning sometimes, it’s hard to establish fair value in a sophisticated market.
The basics of value are what people use to create appraisals. After all, what might be worth a lot to you may be worth little to someone else.
Ultimately no matter what situation you are in, appraisals are the best way to determine fair value. So how do they work?
The overall appraisal process is based on several factors, such as cost, the income it generates, appraisal principles, depreciation occurred, and more. Let’s start by talking about things that increase or decrease property value.
What is Appreciation?
Appreciation is any gain in the value of a property over time from any cause.
Now it’s worth mentioning this definition is strictly for the real estate definition of appreciation. Obviously, appreciation can mean several things. Generally, though, when you hear the word appreciation, you should think of gain in value. And that’s precisely what it is in real estate: when a home or property gains value.
An example of appreciation is if you get your house appraised at $100,000 and five years later it is appraised at $150,000 dollars. That means your house appreciated $50,000. Appreciation is as simple as that.
Now that we covered appreciation, we must discuss the inverse – depreciation.
What is Depreciation?
Depreciation is any loss in the value of a property over time from any cause.
When you hear the word appreciation, you should think of loss in value, it’s that simple.
An example of deprecation is if you get your house appraised at $100,000 and five years later it appraised at $90,000 dollars. That means your house depreciated $10,000.
The Three Types of Depreciation
Deprecation is super important to understand, so important there are actually three main different types. The three types or forms of deprecation you need to know are:
- Functional Obsolescence
- Economic Obsolescence
- Physical Deterioration.
All these things result in the loss of value to a home or property. So yes, deprecation is a bad thing!
Functional obsolescence refers to the loss of property value due to an obsolete design feature.
Examples of causes of functional obsolescence can include:
- Poor or outdated design
- Too many or too few materials or features
- Lack of utility (meaning features are not practical or desirable)
- Overly costly operating expenses
Functional obsolescence usually is fixable. For example, you can update your kitchen or add another garage to the property to maintain design trends.
Economic obsolescence refers to the loss of property value due to external factors, meaning things off the property affecting the property’s value.
Examples of causes of economic obsolescence can include:
- Flight patterns
- A busy highway
- A rise in local crime
Economic obsolescence is usually unfixable by the homeowner. For example, if there is a large amount of crime in your neighborhood no one is expecting homeowners to dress up like superheroes and clean up the streets.
Physical deterioration is the loss of a property’s value as it ages, wears, tears, or decays.
While it is a form of depreciation like functional and economic obsolescence it is NOT a form of Obsolescence. Physical deterioration is just the regular wear and tear a building experiences over time.
One of the best examples of physical deterioration is roofing and shingle replacement. After a while, a roof usually needs a shingle replacement or needs to be replaced completely. Most roofs only last a certain amount of time; during that time of wear and tear, physical deterioration occurs.
The Two Types of Physical Deterioration
Now it’s worth mentioning there are two categories of physical deterioration: curable and incurable. And those are just like they sound one is easier to deal with than the other.
Curable deterioration refers to the form of deterioration that’s economically possible to repair.
For example, maybe there’s some old paint that’s deteriorated, and dealing with that would eliminate the problem. It’s curable, it’s fixable, and it’s economically feasible.
Incurable deterioration is incurable, meaning the cost of repairing an item surpasses the value it adds to the structure; the item is considered incurable even if you can fix it.
An example of that would be the foundation of a property is faulty. There is no way of handling that without completely altering the property.
Short Lived Physical Deterioration
A third type of deterioration exists, but it’s not generally accepted everywhere. Some appraisers use the phrase to describe items that wear out faster than the improvements themselves.
Now that we’ve covered appreciation, depreciation, and value we can finally discuss appraisal.
Real estate appraisal is an integral part of the home buying and selling process. Appraisals are required for any home sale that requires a mortgage and is more common than you may think.
What Is a Real Estate Appraisal?
A real estate appraisal is an estimation of the market value of a home by a licensed appraiser that is hired by the mortgage lender.
Here’s an example, after deciding they wanted to buy the house, Mr. and Mrs. Smith went to the bank to get a loan. The bank is making an investment and therefore pays for an appraiser to ensure the value of the home. The appraiser does an evaluation of the outside and inside of the home in order to fully estimate the value.
What Is the Purpose of a Real Estate Appraisal?
There are a lot of reasons for a real estate appraisal, but they are all doing it for one reason: to determine the market value of the home.
Appraisers provide insight into the value of the home for buyers, sellers, lenders, lawyers, accountants, etc. Many people rely on these reports to make good business decisions.
Appraisals for a Mortgage
This is the most conventional type of appraisal and is generally used by banks to ensure that the home you are getting is a good deal. The bank is investing in your home and therefore wants its investment to be secure.
If not done properly, the bank could end up losing a lot of money if you were to foreclose. Basically, they don’t want you to be the only one determining if you are getting a good deal.
Here are some examples:
Mr. Smith has decided that he wants to move into a specific house valued at $250,000 and makes a down payment of $50,000. He goes to a mortgage lender who sends an appraiser out to the property. He values the house at $250,000; therefore, so they are willing to issue the mortgage. Mr. Smith stops making his payments, so the mortgage lender acquires the house. They sell the house for $250,000 and don’t lose any money.
Alternatively, if they had not sent the appraiser out to the property, the house could be worth anything. After Mr. Smith stops making payments, the mortgage lender acquires the house. Uh oh, it turns out that Mr. Smith overpaid on the house, and now the lender can only sell the house for $150,000 and loses money.
Appraisals for Estate Valuation
Sometimes home buyers seek an appraisal to evaluate the value of an estate for the purposes of inheritance or divorce. In order to properly split up assets, the value of those assets must first be valued.
Here is an example:
Rachel and Ian had their father pass away recently. He owned two homes, one in California and one in Ohio. Rachel and Ian’s father stated in his will that he wanted his property split 50/50. Rachel likes the house in California, and Ian likes the home in Ohio, so their initial thought was just to each take a house. Ian’s wife asked him to get an appraisal on both of the houses and found out that the home in California was worth three times as much as the house in Ohio. Now that they have an appraisal, they know that each of them taking a house would not be respecting their father’s wishes.
These types of appraisals are fairly common and are recommended by many lawyers during the process of fulfilling a will or completing a divorce.
Appraisals for Business Purposes
This is a pretty broad category. Businesses rely on real estate appraisals to conduct all sorts of business activities. Appraisals are required when businesses are negotiating mergers, leases, and acquisitions. They also use appraisals to determine the value of their assets if they deal with properties as their normal mode of business.
Appraisals are required whenever a property is sold, mortgaged, taxed, insured, or even improved upon. Businesses love to keep tabs on exactly where all their money is, and appraisals are a way to do that. If a business owns several properties but has no idea what those properties are worth, then it can be hard to judge how much the company is worth as a whole.
Who Can Perform Real Estate Appraisals?
Real estate appraisals are performed by an appraiser that is not associated with the lender. The appraiser is intended to be unbiased when it comes to the property, and should not be connected financially or otherwise to any party.
Real Estate Appraisers Are Not Perfect
Many people have the false assumption that what the real estate appraiser says is final, which is not always true. Although they are really good at their job, sometimes they miss something that could influence the market value of the property. Many buyers and sellers choose to get a second opinion if the results of the first appraiser were undesirable.
An Appraisal Is an Opinion
Although backed by evidence, a real estate appraisal is an opinion on what your home is worth. There are so many factors that go into this. For example, let’s say that two houses that were sold in the area both had extensive improvements that resulted in a higher sale price. That higher sale price could influence the appraisal because “similar” homes in the area were sold for much more than your home is worth. Although this isn’t going to happen every time, it can influence things. There are hundreds of factors that appraisers use in their analysis, and they could easily miss something.
Although paid for by the buyer, generally, the appraiser’s work is usually owned by the bank that called for it. They can choose who that appraiser is going to be shared with. Many people decide to contract out their own appraiser before going to any bank, and that way they can accurately judge the worth of their own home as well as show it to possible buyers if necessary.
What Influences a Real Estate Appraisal?
There are a lot of factors that influence an appraiser’s estimation of market value, here’s a quick list:
- Building materials
- Age of home and renovations
- Style and layout
- Square footage
- Number of bedrooms and bathrooms
- Storage space
- The market and comparable homes
- And more!
Each of those attributes will influence an appraiser’s estimation, some more than others.
What Is a Real Estate Inspection?
Real estate inspections are not real estate appraisals, but they are very interconnected.
A real estate inspection is performed to understand the current condition of a home. The inspector looks for things such as water damage, pest infestations, roof conditions, and a lot more. This inspection is used by the appraiser to determine the current value of the home.
Let’s say, Mr. Smith was selling his home and was showing it to potential buyers. The buyers decided to purchase the home, but before signing any papers, the real estate inspector went to inspect the home and discovered the presence of a mild termite infestation that dropped the value of the home. After some renegotiation, the buyer still decided to go through with buying the home but for a reduced price.
What’s the Difference Between a Real Estate Inspection and a Real Estate Appraisal?
A real estate inspection and real estate appraisal are very similar, but both have different goals in mind.
A real estate appraiser’s goal is to determine the market value of the home, while a real estate inspector’s goal is to discover any issues or problems on the property. A lot of the appraiser’s work can be done without looking at your home by researching other homes that have been sold in the area, while an inspector must visit the property to determine anything.
Generally, the inspection will happen first so that the appraiser can take a look at the results. If any problems are discovered during inspection, the appraiser will take that into account when determining the market value of the property.
Simply put, the real estate inspector is going to look for problems in each part of your home, while the appraiser is going to look at the value of everything.
How do Appraisals Work? Approaches and Principles
It’s essential to understand the steps in the appraisal process. With a combination of each step, appraisers derive fair market value. There are different approaches and principles appraisers use, and it’s essential you are familiar with them come exam day and for your real estate career.
What are the 3 Types of Appraisal Approaches?
There are three different main approaches that appraisers use while they make an appraisal. They are:
- Market Data Approach, which is also commonly called the sales comparison approach
- Cost Approach, also referred to as summation
- Income Approach, which is also known as capitalization
What is the Market Data Approach?
The market data approach, also known as the sales comparison approach, involves comparing a property to other recently sold properties in the same area of similar size and condition.
For residential real estate, the market data approach is typically regarded as the most accurate comparison method. The market data approach is also ideal for new or unused lots; it is easier to directly compare new lots’ properties because there are few variables on the properties.
Watch the video below to learn more about the market data approach:
What is the Cost Approach?
The cost approach is a real estate appraisal method that determines how much a property would cost to replace it, subtracting depreciation. The method is based on the concept that a property’s price should be determined by the value of the land plus the cost of building on it (subtracting the depreciation cost).
It is the only form of real estate appraisal that does not use the active market to establish a property’s value.
Rather than basing the value on other comparable properties, the cost method to valuation essentially based the worth on how much it would cost to rebuild it if it were destroyed, so the replacement cost. This strategy assumes that buyers will not pay more for a building than they would if they had to cover the current price of developing a comparable structure.
Watch the video below to learn more about the cost approach:
What is the Income Approach?
The income approach is a process used by appraisers to determine the market value of a property based on its income. The approach is based on the finance concept of discounted cash flow analysis. Under the income method, the property’s current worth is the present value of the future cash flows that the owner can expect to receive.
This method is most prevalent for commercial properties with tenants because it relies on rental income. It’s calculated by dividing the rent collected net operating income (NOI) by the capitalization rate.
Watch the video below to learn more about the income approach:
Next, we have to talk about appraisal principles, another essential element included in the appraisal process.
What are Appraisal Principles?
Appraisal principles, like the different approaches, are used by real estate appraisers and investors to help establish particular property values. There are five that are essential to understand, and we have videos covering each one specifically. The five appraisal principles you need to know are:
- Principle of Substitution
- Principle of Conformity
- Principle of Highest and Best Use
- Principle of Contribution
- Principle of Progression
What is the Principle of Substitution?
The principle of substitution states that a buyer will not pay more for a property than the cost of an equally desirable property.
In real estate, when comparing identical houses, the buyer theoretically should always choose the cheaper house. The principle simply means buyers usually don’t pay more when they don’t have to.
Principle of Substitution Example
If a house is selling for $500,000 and an equally desirable substitute is selling for $400,000, according to the principle of substitution, the first house will not sell.
What is the Principle of Conformity?
The principle of conformity states that the value of a property is maximized when it complies with the design and features of the surrounding area.
This means as long as a property is similar to other properties in the neighborhood (condition, age, and size), it is more likely to appeal to potential buyers and thus increase its respective value. It’s worth noting if a house does not adhere to the same style and design as neighboring properties, it can cause depreciation or a decrease in value.
Principle of Conformity Example
An example of the principle of conformity would be if you had a two-car garage in a neighborhood filled with properties with one-car garages. An increase would occur if your property was placed in a neighborhood with other two-car garages.
Obviously, most properties you cannot pick up and move, but appraisers use this principle to determine value for properties that are not in line with each other.
What is the Principle of Highest and Best Use?
The principle of highest and best use of a property is the concept that finding the best use of real estate would create its greatest net return.
This appraisal principle is designed to ask a simple yet complex question: What is the maximum way to achieve the most significant return on a particular parcel of real estate, OR what is the highest and best use?
The highest and best use of a property is the use of a property that would create the greatest net return over time. Sometimes highest and best use is referred to on the real estate exam as the greatest net return. Don’t be concerned if you see this. Highest and best use and greatest net return can be used interchangeably.
Principle of Highest and Best Use Example
Let’s say you owned a vacant lot in a residential neighborhood. If you constructed a parking garage in that residential neighborhood, chances are you would not be getting the highest value from that property. Instead, building a house would be a safer bet and thus would be the highest and best use.
What is the Principle of Contribution?
The principle of contribution states that the actual worth of an improvement is what contributes to the property’s market value, not the cost of the improvement.
Worth and cost are not always the same thing when it comes to real estate. For example, a pool could add $5000 to the value of a home but cost $10,000 to build.
There are also times when an improvement can add more value than the cost. For example, adding an additional room can be an easy simple job to complete for handypeople. So maybe the cost to build is $1000, but the value it adds is $2000.
Principle of Contribution Example
Appraiser Jack was hired to prepare a feasibility study for a 12-unit apartment complex in which the owner is considering putting in a swimming pool. Which basic principle of appraising should Jack use?
Jack should use contribution. Contribution is most commonly applied to determine how renovation and property changes may affect the property’s overall cost. In this case, since the owner wants a feasibility study, contribution would need to be used. Swimming pools are a typical contribution example.
What is the Principle of Progression?
The principle of progression states that the value of a property increases when more valuable properties are built in the area.
The idea is that if your property is worth $250,000 and is surrounded by $400,000 properties, its value will likely go up. Meaning in plain terms, the value of a house increases when more valuable houses are built in the surrounding neighborhood.
Principle of Contribution Example
Let’s say your grandparents built a house in the ’70s, and ever since, slowly and steadily, other houses in the neighborhood were being built. New houses were built every so often for years until the community was filled with large, updated homes, except for your grandparents. While many people see this as a problem, a wise investor would look at this as an opportunity.
If the surrounding neighborhood has properties worth more than you, your property value will go up. What’s even more incredible is with some improvements, sometimes major or minor your property can reach that value. That’s the principle of progression.
Is that Everything You Need to Know About Real Estate Appraisal and Valuation?
Pretty much. We covered a lot, and hopefully, the materials aren’t too intimidating, but we always like to be thorough. For everyone studying for your real estate exam, if you can master these materials, you’ll be good to go come exam day. As for other topics, check out our contract guide or our premium real estate exam prep packages.
Thanks for reading; until next time!