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Property Appraisal: Definition, Purpose & Process

Instructor: Ian Lord

Ian is a real estate investor, MBA, former health professions educator, and Air Force veteran.

Let's take a look at property appraisal and broad explanations of different approaches. We'll discuss how these approaches work and what purposes they serve, and help understand how they tie into the final reconciliation of value.

Property Appraisal Definition

Before Bob can complete his home purchase, the lender is going to insist on an appraisal. Why? Lenders need to be sure the house is worth at least the mortgage amount so if they have to sell it in foreclosure they won't take a loss. An appraiser is a neutral third party paid by the lender, homeowner, or home buyer. An appraiser's job is to determine an estimate of the property's fair market value.

Property appraisal is the process of creating an estimate of value for real estate. Fair market value (FMV) is the price a property would sell for given a reasonable amount of time and assumes the buyer and seller know about all the details of the property. For the appraiser to get an accurate value, they must collect appropriate data and apply one or more approaches. He or she will then explain the appraisal decision in a final reconciliation of value.

FMV isn't always clear. Value differs with who the buyer is. A rental investor may value a property differently than someone looking to buy a house to live in. Appraisers use three different approaches to estimate value. Each approach tends to favor certain kinds of deals. The three can be used in concert with each other to create a more complete value estimate.

Data Collection

The appraiser must collect accurate data to make an informed estimate. The following data is useful depending on the exact approach being used:

  • Recent sale prices of similar homes
  • New construction costs
  • Value of various improvements and their expected lifespans for depreciation
  • Rental prices and predictable expenses of similar homes

Appraisers can pull prices and rental information from the Multiple Listing Service (MLS) database or third party websites that share some of the MLS information. The MLS is the central listing used by agents which shows current and recently sold properties. An appraiser can learn how much new construction and remodeling costs by figuring out the materials and labor charged by experienced builders in the local market. Major replacements or additions to a house are depreciated over 27.5 years, or as directed in IRS guidelines. And predictable expenses? Just think of the regular costs that apply to any house: taxes, insurance, and utilities.

Property Appraisal Approaches

What is Bob's intent for the house? Bob's lender will instruct the appraiser to consider the desired use. Let's look at common approaches.

The cost approach expresses value as the cost of building an identical property on a different piece of land nearby. It might be cheaper to build a new property instead of buying an existing one. It is useful in valuing homes in new construction areas. In older areas, new buildings may not be practical.

The comparative sales approach is most often used in retail purchasing. The appraiser looks at what similar homes in the area have recently sold for. Any differences between those homes and the one for sale are adjusted. Adjustments show how value changes with the differences. An extra bedroom on the house for sale might add value compared to the recently sold home. A smaller yard may mean a decrease in value compared to one of the recent sales.

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