Real estate is more than just buildings and land. An appraisal is an integral part of valuing a real estate asset. Property valuation is what the real estate economy is built on because it establishes a baseline value in the homes we live in, where we invest, how much a business or collectible is worth, or even Grandma’s precious antique. Understanding the concept of real estate appraisals and valuations is crucial to any home purchase, investment, and refinance. Some terms may sound technical, but they hold the keys to unlocking the value and potential of real property.
Key Takeaways:
- The appraisal should ideally match the loan amount. Lenders calculate Loan-to-Value (LTV) based on appraised value, not the purchase price.
- The loan amount can differ significantly based on the LTV percentage and the down payment you make.
- If the purchase price exceeds the appraisal value, it’s possible to renegotiate with the seller or cover the appraisal gap yourself.
- Disputing specific comparables or adjustments is another option but requires a knowledgeable buyer’s agent.
- If the negotiations fail, you can cancel the deal.
This article on real estate appraisals and valuations will introduce you to the essentials of this fundamental concept in the real estate world. Whether you’re a first-time homebuyer, a seasoned investor, or just curious about how property values work in the real world, this article will shed light on the basics of real estate appraisals and valuations. Hopefully, in the end, you’ll have a clearer picture of how this crucial piece in the purchasing and sales process can influence your decision, see how it shapes markets, and impact your real estate experiences.
Basics of Real Estate Appraisals
An appraisal is defined by the Dictionary of Real Estate Appraisal, 4th ed., published by The Appraisal Institute, which describes it as “The act or process of developing an opinion of value, or of pertaining to appraising and related functions such as appraisal practice or appraisal services.”
The appraiser is responsible for determining the appraised value of a property. The appraised value is essential for buying and selling real estate, obtaining financing, settling estates, property taxes, and making investment decisions. The appraised value is an estimate of a property’s value based on that point in time.
Appraiser’s Role
The appraiser is responsible for property evaluation, data collection, market analysis, valuation method choices, report write-up, and adhering to ethical and legal standards.
- Property evaluation: the analysis of physical location, property, and economic characteristics, property inspection, assessment of the property’s condition, and note any unique features.
- Data collection: gathering the comparables (like-kind properties), market trends, zoning, and other factors affecting property values.
- Market analysis: an in-depth analysis of supply and demand, economic trends such as when Covid hit, and other factors that can impact property values.
- Valuation method: there are three valuation methods: the sales comparison approach (the most common), the cost approach, and the income approach, which is used for income-producing property.
- Report write-up: after gathering all the information, the appraiser writes up a detailed report with their findings, chosen valuation method, and lists a final estimated value of the property. This report can be used by the bank, buyer, and seller (depending on who ordered the appraisal).
- Adhering to ethical and legal standards: appraisers are bound by ethical standards and legal requirements. Their valuations must be impartial, void of conflict of interest, and adhere to USPAP, the Uniform Standards of Professional Appraisal Practice.
Appraiser Qualifications
Appraisers undergo extensive education and training, and many have advanced education in real estate, finance, or economics and undergo a 75-hour education before an internship and another 150 hours of licensing education.
All appraisers must be licensed or certified and gain practical experience by a state-mandated number of hours and not before a certain number of years. They are also made to complete continuing education every two years, which includes classes that mandate adherence to ethical standards and code of ethics. All appraisers must comply with the Uniform Standards of Professional Appraisers, which governs the conduct and reporting of appraisals.
The Appraisal Process
The appraisal process begins with an ocular inspection, data collection, market analysis, chosen valuation methods, and report preparation. It is a systematic procedure used to determine the value of a home, commercial property, or land. Its goal is to provide an unbiased, well-supported estimate of a property’s fair market value.
It begins with a letter of engagement. The letter of engagement engages the services of the appraiser. In a home purchase, it is the lender that requests the appraisal. Then, the appraiser goes out to the property for a physical inspection and gathers information on the size, condition, layout, and any unique features that may affect the property’s value.
The appraiser returns to their desk and collects other relevant data from various sources, such as recent sales in the neighborhood similar to the property they just visited. These like-kind properties are called comparables or comps. They also note zoning regulations, market trends, and other factors that could impact the property value.
As they prepare to write the report, they will use one or more of the three valuation models to estimate the property’s value. In the case of a home purchase, it will be the sales comparison approach, which compares the subject property to recently sold comparable properties.
The cost approach calculates the cost to replace or reproduce the property, factoring in depreciation. This valuation model is rarely used and would be used for unique properties like power plants or the Notre Dame in Paris, which suffered a fire in 2019.
Lastly is the income approach, which applies to income-producing properties and estimates value based on potential rental income. The appraiser will use the income approach with the sales comparison approach if you want to buy a multifamily property, retail or commercial space, or a large apartment building with tenants.
The appraiser then makes the necessary adjustments to account for the differences between the properties since no two properties are alike and reconciles those values to arrive at the final estimated value.
The Role of Appraisals in Real Estate Transactions
Real estate appraisals play a crucial role in real estate transactions by objectively and professionally assessing a property’s value. Their role is diverse and impacts multiple aspects of real estate transactions.
Buyer seller negotiations
Appraisals provide an unbiased, independent evaluation of the property’s worth. Buyers can avoid overpaying, while sellers can avoid undervaluing their property. The report helps establish fair market value for the property and is the basis for both buyer and seller to negotiate a reasonable sale price.
Mortgage Lending
Lenders require appraisals for loans for real estate purchases. The appraisal ensures that the property’s value supports the loan amount. It helps lenders manage risk and determine the loan-to-value (LTV) ratio, which affects the terms and interest rates of the mortgage. Appraisals are ordered to protect the bank’s interest and not you.
Tax Assessments
Appraisals are used for property tax assessment purposes by local governments. Accurate valuations help ensure that property taxes are fair and equitable and serve a relative measure of value on how the government’s municipality determines the property tax amount you will pay.
Tax assessments typically fall below the appraised or actual market value. To determine value, tax assessments commonly rely on mass appraisal techniques. These techniques involve valuing a group of properties as of a specific date using shared data, standardized methods, and statistical testing. By employing this approach, tax authorities can effectively assess properties while maintaining consistency and accuracy.
Tax and Wealth Planning
Appraisals are essential when assessing the value of real property for estate planning, inheritance, and settling estates in probate. They provide a fair and equitable value for tax purposes for the distribution of assets.
Beneficiaries may want to know the value of the share they receive and the taxes for which they may be liable. The appraisal report can make distributing assets simpler and more efficient.
Investment decisions
Real estate investors use appraisals to assess the potential profitability of investment properties. The appraisal helps determine whether the purchase price aligns with the property’s income potential, guiding investment decisions.
Appraisal reports for investment decisions typically provide an income approach portion for investment properties that provide rental income. In this approach, the market value is based upon the ability of the property to provide a suitable return as an investment.
Insurance Coverage
Property insurance companies may require appraisals to set the coverage amount accurately. In the insurance industry, appraisals are used to calculate the cost of replacing the property or determine the damage to the property after a covered event. When the carrier and the policyholder disagree on the loss amount, it is a simpler, cleaner alternative to a lawsuit.
FAQ
What is an example of appraised value?
For example, a buyer might offer $500,000 for a home that the seller marketed at $550,000, and the appraisal report says it’s valued at $525,000. The appraisal gap could lead to negotiations between the seller and buyers with a potential compromise price somewhere in between.
The buyer would have to come up with the extra $25,000, and the seller would have to come down in price $25,000 if both parties were amicable to negotiate to the report’s appraised value. Sometimes, the appraised value can be higher than the market value, especially in an appreciating marketplace and conversely in a down market.
What is the difference between appraised value and selling price?
According to an appraiser’s professional estimate of value, appraised value states what the home is worth. Unlike the listing price, the house’s appraised value may not be what sellers ask for their home. While the sales price measures how much buyers are willing to pay for the property, the appraised value is supposed to gauge the property’s value at that specific time.
Property valuations can impact real estate transactions, especially financing. Let’s use our $550,000 home from above, and the sellers reduced the sale price to $525,000. The borrower would need to increase the down payment to keep the loan-to-value (LTV) ratio at 80% if they wanted to put the customary 20% downpayment.
LTV is calculated by the current loan balance/ current appraised value= LTV
You were planning on putting $100,000 (20%) down based on a $500,000 sale price, and the seller agreed to the $525,000, you would have to either come up with that extra $25,000 in cash or assume a larger loan of $425,000 which brings your new LTV to 76%. Depending on your loan amount and lender, they may not want to lend to you if you put less than 20% down. Putting less than 20% down could also affect your interest rate and kick in private mortgage insurance, which can affect the affordability of the home. The appraisal report is one example of how a piece of paper can instantly throw things out of whack.
Does appraisal have to match the purchase price or loan amount?
The appraisal should come in as close as possible to the loan amount, and lenders use the appraised value to calculate our LTV, not the purchase price. Loan amounts can differ from someone taking a 95% LTV versus someone who does a conventional loan of 20% down and taking an 80% LTV. Lenders will only allow a loan amount based on how much the home is worth on the appraisal report.
What happens if the purchase price is higher than the appraisal?
You can return to the negotiating table with the seller to try negotiating the purchase price as the appraised value or at least ask the seller to meet you halfway. So, if the difference is $10,000, the seller can bring down the sale price by $ 5,000, and you contribute the other $5,000 in cash to cover the appraisal gap.
A controversial option is to refute specific comparables or adjustments. If you find a better comp than what the appraiser has listed in the report that you feel is a better match to the subject property, you can broach this to the appraiser. In this technical part, you will need the help of your buyer’s agent. And if all else fails, you can cancel the deal.
Conclusion
In conclusion, real estate appraisals are the bedrock of property transactions. They provide a fair, well-supported, and impartial assessment of a property’s value. They help you make informed buying, selling, and investing decisions. With this understanding, you can confidently navigate the real estate world, knowing that appraisals unlock the secrets behind property values and profitability, making them your trusted guide in your real estate journey.
