When it comes time to buy a new investment property, the bank’s appraisal can make or break a deal. If the property appraises too low, your financing might fall through. In other cases, the bank might approve the loan but require new contingencies, such as a higher down payment—putting you on the spot to fill the gap.
Sellers need to be equally concerned about their property’s appraised value. A low appraisal can drastically affect one’s ability to sell the property, particularly to someone who plans on financing the deal instead of paying for it in cash.
Real estate investors tend to pay a lot of attention to what’s happening in the capital markets. Are interest rates rising? Will new construction affect pricing? All of this definitely matters—but too often, the importance of a strong appraisal gets lost.
Here’s what you need to know about appraisals, including how the evaluator determines the property’s value and what you can do to set the stage for getting the best possible real estate appraisal.
Real Estate Appraisals 101
What is a Real Estate Appraisal?
An appraisal is the act or process of developing an opinion of value. The valuation process is a systematic procedure that an independent appraiser follows to answer a client’s question about real property value (usually, market value). A real estate appraisal is also commonly referred to as a “property valuation”.
It is important to note that the appraised value is different than the assessed value. The assessed value is determined by the municipality in which the property is located, and can be drastically lower than the appraised value.
When Would You Need an Appraisal?
A real estate appraisal is needed whenever a person is financing the purchase of a property, or when an owner is looking to refinance. Someone might also have an appraisal done before listing their property for sale in order to determine a fair listing price; this is particularly helpful if the property is unique and no local comps are available. Appraisals are commonly required during estate sales and divorces, and they can also be used to determine tax liabilities.
Who Conducts a Real Estate Appraisal?
Most states require appraisers to be licensed or certified. Appraisers have been specially trained to develop independent opinions of value. If an appraisal is required as a condition of your loan (whether you’re purchasing or refinancing), the bank will initiate, hire, and oversee the appraisal. New regulations prohibit Fannie Mae and Freddie Mac lenders from having direct contact with appraisers, so most banks will initiate the appraisal through an appraisal management company that has a pool of appraisers from which to draw.
If you’re getting an appraisal done to establish the home’s value before you sell, you can hire the appraiser directly.Real estate appraisals 101: Learn the basics on the #BuildiumBlog now! Click To Tweet
Understanding Real Estate Appraisals
There are three different approaches that appraisers use to determine a property’s value:
The Sales Comparison Approach
As the name implies, this method compares a property’s characteristics with those of comparable properties that have recently sold in similar transactions. Because no two properties are exactly alike, the valuations of comparable properties are generally averaged to establish a fair market value for the property being appraised. Adjustments can be made as features vary. For instance, a property may be discounted if the units are smaller or if there is less parking. This approach is sometimes called the “market approach” and is the most widely used when evaluating residential real estate. However, it’s reliant upon the existence of comparable properties in the area.
The Cost Approach
This method assumes that the buyer will not pay more for a property than it would cost to build an equivalent. It begins with an evaluation of the site’s value, as though it were vacant, and then calculates the replacement cost of any existing building structures, subtracting depreciation.
The Income Capitalization Approach
Commonly referred to as the “income approach,” this method is often used when appraising investment properties. It values a property based upon its rental history and its revenue-generating potential. This method is more complicated than the others: A property’s direct capitalization, discounted cash flow, and gross income multiplier are all commonly analyzed as part of this approach.
Most appraisals will use some combination of these approaches. The values established through each approach are reconciled into one final opinion of a property’s market value.
What Other Factors Influence a Property’s Appraised Value?
There are certain factors that influence a property’s appraised value, including local market conditions (basic supply and demand) and macroeconomic trends (like a national recession). The principles of substitution, balance, and externalities can also help explain shifts in value.
What Can Landlords Do to Increase Their Appraised Value?
Appraisers collect a significant amount of data before calculating their opinion of value. To ensure that you get the best possible appraisal, make sure to provide the appraiser with any information that could be relevant; let the appraiser decide whether that information applies.
- Give the appraiser information about positive influences in the immediate area. For instance, if you know that a train stop is being planned to make your neighborhood a more convenient place to live, be sure the appraiser knows about it.
- If you’ve made any improvements to the property, document those repairs and renovations. Use a spreadsheet to detail the costs, and keep before-and-after photos that can be shared with the appraiser. If possible, provide copies of receipts, particularly if the renovation was expensive.
- Turn over copies of bank statements and rent rolls to show the appraiser your actual income and expenses for the property. This will help to quell any fears the appraiser may have about the property’s ability to generate a certain level of income.
- If the property is currently being rented, ask (or incentivize) your tenants to tidy up before the appraiser comes to look at the property. Don’t forget the exterior, too—as we all know, first impressions are everything!
How to Challenge an Appraisal
If you feel that the appraisal is unfairly low, you are well within your right to challenge the appraiser’s analysis. Grounds for challenging an appraisal may include information about the property that is incorrect; or your ability to produce comps from the area that are more recent, closer, or more comparable overall than those used in the appraisal report. You might also challenge an appraisal if only one approach was used, and you feel that an alternative approach would have yielded a much different result.
It’s ultimately up to the bank to determine whether or not your challenge has merit. The bank may entertain a second appraisal, but will usually require you to cover the cost of hiring someone else. Having to pay the fee upfront may seem unfair, but if it’s going to result in a better appraisal, it may be worth it. If the two appraisals turn out to be much different, your lender will likely take the average of the two. In some cases, though it’s uncommon, a bank might suggest getting a third appraisal and will take the middle value of the three.
In any real estate transaction, the appraisal is one of the most important components if any party needs to lock in financing. To get the best results, be sure that you understand the appraisal process, the data being analyzed, and the parties involved in the decision-making. There are only so many factors you can control, so do your best to control those—and of course, challenge the appraisal if necessary.Read more on Scaling